Labor and the Employment Market: It’s Complicated

Quick takes:

• Rate hikes aiming to cool inflation
• Tight labor market most-direct target
• Weakened labor market should slow wage growth
• Slower job growth could equal less demand for office space
• But weaker labor market could equal greater RTO

Inflation remains the primary economic concern for the economy. It is dampening consumer spirits and forcing central banks like the Fed to attempt to address it. In doing so, the Fed is taking aim at the labor market. Why? Because the Fed sees the labor market as its most direct (and important) target in the battle against inflation. As the Fed remains limited in its ability to target the economy, its attempt to bring down inflation will likely produce intended and unintended consequences for both the economy and the office market.

The inflation playbook

Going after inflation, the Fed will attempt to use the standard playbook. The Fed is raising interest rates in an attempt to  soften the interest-rate sensitive parts of the economy such as housing, autos, and more broadly, durable goods. By raising rates and cooling those parts of the economy, the Fed is trying to tamp down demand for those goods and, in the process, reduce hiring. Reduced hiring in interest-rate sensitive goods produces direct and indirect reductions in spending (via the multiplier effect). This should broadly reduce hiring and spending in the broader economy as other industries see reduced revenues. The risk, of course, remains that the Fed overshoots, pulls back on demand too much and causes a recession. Yet, the Fed believes that it has some runway here.  The job market continues to generate hundreds of thousands of net new jobs per month, unemployment claims continue to hover near record lows, and the number of open jobs still lurks near record-high levels despite strong job gains. The Fed likely views this as evidence of excess labor demand. The Fed believes that it must reduce demand for labor to cool wage growth and, consequently, inflation.

While the Fed is primarily targeting demand, the Fed also possesses some limited ability to impact labor supply as well. As higher interest rates reduce the value of many asset classes, many households’ wealth has declined considerably in recent months. While that does not pose a large risk to younger workers in the short run, it potentially imperils older workers who are closer to retirement age. That could incentivize them to return to the labor force, also boosting labor supply in the process. This combination of reduced demand and increased supply could loosen the labor market - slowing job growth, causing the unemployment rate to tick up, and even raising the unemployment rate. While the Fed has not said as much, they might willingly trade some disruption in the labor market for a reduction in inflation, as it attempts to fulfill its dual mandate of full employment and price stability. If the Fed believes that the labor market is too tight, contributing to inflation, then such a tradeoff would seem logical.

Connection to the office market

How does this connect to the office market? In a complex way. Most obviously, slowing the labor market typically reduces demand for office space. The Fed is trying to use its levers to slow excess demand, but rate hikes can produce collateral damage, including jobs that typically utilize (to some extent) office space. As higher rates reduce demand, traditional office-using employment typically slows, which frequently results in lower net absorption, higher vacancy rates, increases in concessions, and slower (if not negative) rent growth.

In a typical market cycle, that would conclude the story. But this cycle remains far from typical. Counterintuitively, such reduction in demand could also produce benefits for the office market. Currently, return to office (RTO) looks like a tough slog. With the labor market so tight, labor demand has the upper hand. Consequently, employers are struggling with what we call the First In Line At The Buffet/First On The Dance Floor Dilemma. Employers are finding it difficult to entice workers back because a tight labor market enables workers to find alternative employment easily. If employers threaten workers with mandatory RTO, they can simply leave for another employer.

But, if higher interest rates reduce demand for labor AND increase labor supply, that could weaken the labor market enough to return some power back to employers and give them greater leverage to call workers back to offices. To be clear, we are NOT rooting against the labor market. After the previous economic expansion, when the labor market struggled until latter stages, it feels unfortunate that labor is now getting painted as part of the inflation problem. But weakening the hand of labor could enable employers call workers back to offices more easily. Yet there are two important qualifications. First, the Fed could certainly go too far and cause a recession. While that would certainly weaken labor’s position, it would also likely result in job losses and reduce demand for space, even as some workers had to return. Second, as we have repeatedly mentioned, the labor shortage is structural because of demographics. Therefore, any weakening from the Fed should prove ephemeral and, ultimately, labor would retain the upper hand. But in the short run, employers could potentially reestablish RTO norms.

Outlook

The Fed remains tasked with walking a fine line – do not do too little but also do not too much. That puts the broader economy and the office market in a precarious position. For now, our base case does not include a recession per se, but some loosening in the labor market as job growth decelerates. While we normally view that as a negative for the office market, it could present a silver lining during this unique cycle.