By Leonard F. Herk and Patrick Coate
Posted Date: August 8, 2022
The Economic Outlook for Q2 2022
These are perplexing times. Surveying the economy at midyear, three observations stand out.
Output and employment in the United States have surpassed pre-COVID levels. The period of immediate economic recovery from the 2020 COVID pandemic is over, although the COVID virus persists in new mutations. Despite rising consumer prices and anxiety that a recession may be in prospect, economic data for the United States through June are remarkably sanguine. The US economy added nearly a half million private sector jobs in July, about 100,000 more than the average monthly increase from April to June. Unemployment is down to a very low 3.5% rate, and employer surveys show continuing strong demand for new hires.
While demand for goods and services is robust, numerous indications show that US economic growth is slowing—as is to be expected following the rapid recovery of the last two years. New weekly unemployment claims rose above 250,000 for the last three weeks of July, the highest readings in 2022 but still comparable to pre-COVID rates. Annual wage growth for production and nonsupervisory workers was above 6% for the year ending in July, well above the pre-COVID norm of 3% to 3.5% per year. Wage increases appear to be flattening out, a favorable sign for bringing down future inflation.
An overhanging dark cloud is price inflation. The Consumer Price Index (CPI) increased by 9.1% for the 12 months ending in June, up from 8.6% in May and far above the US Federal Reserve’s inflation target rate of 2% per year. Price inflation is at least bothersome—it complicates contracts denominated in cash—and can be destructive if sustained and severe. A widespread concern is that the US Federal Reserve’s efforts to counteract price inflation may trigger a recession.
To be clear, economic data through midyear do not point to an imminent recession, let alone show that a recession has already begun. As to the latter point, a preliminary estimate of growth in gross domestic product (GDP) recently came in at ‒0.9% annualized for the second quarter. Following a decline of 1.6% in the first quarter, the latest GDP number is causing some people to conclude that a recession is already here. We do not agree.
While a rule of thumb is that a recession ought to include at least two quarters of negative GDP growth, that criterion alone is not conclusive. In fact, there are no “official rules” for calling a recession (as opposed to an economic slowdown or downturn) nor does it make sense to distinguish a “technical” recession from the real thing.A thoughtful discussion of what ought to count as a recession and how recessions in the United States are retrospectively dated is in Recession: What Does It Mean? The New York Times, July 26, 2022.
Taken out of context, negative GDP growth for a couple of quarters can be misleading. The most persuasive evidence of a recession ought to be evident in labor markets: a jump in layoffs and the unemployment rate accompanied by a significant drop in job creation and slow wage growth. Through midyear, labor markets in the United States are exhibiting none of these symptoms.
But even accepting that recession is neither here nor immediately imminent, how likely is a recession in the next year and what might bring it about? For these questions, the coincidence of high price inflation with signs of an incipient slowdown in labor markets is worrisome and perplexing.
Besides readjusting to huge drop-offs in demand during the COVID recession of 2020 and strong demand recovery since then, both US and global economies face disruptions in input markets (materials and labor shortages) that are pushing up costs of supply. Price movements in response to demand and supply shocks are normal: they serve to reequilibrate markets and in so doing change the relative prices of different goods and services. In ordinary times, market shocks and relative price changes resulting from them are individually small and collectively diverse; consequently, they do not produce big movements in indices of general price inflation like the CPI. But when—as today—big and directionally similar shocks to demand and supply push up prices for major consumption categories like energy, food, and housing, then increases in the relative prices of these items also shows up as general price inflation via the CPI.
This is the unique situation confronting US and global economies. It is worrisome because a slowing global economy may signal the beginning of a downturn of uncertain severity and duration, perhaps a recession. It is perplexing because today’s inflationary experience in large measure falls outside the scope of traditional policy responses designed to combat inflation.
This issue of the QEB begins with a survey of US labor markets. Data for the second quarter show strong job growth and hiring, but plateauing wage increases. The following sections focus on related topics of price inflation and recession. We break down the CPI to identify key sources of US price inflation—important contributors are energy, food, and housing—and consider the market dynamics behind them. We examine the connection between today’s inflation and the prospect of recession later this year or next. In particular, we consider interest rate policy by the US Federal Reserve as a tool for curbing aggregate demand and influencing future inflationary expectations. Finally, we weigh the risks of inflation and recession from the perspective of workers compensation insurance.
Labor Markets and Employment, Wages, and Prices
Labor Markets and Employment. Data through the first seven months of 2022 show continued strength in the US labor market. Job creation, hiring demand, and unemployment rates for the overall economy are holding steady. The big jump in employment in July was surprising, and continues a run of solid job growth through the second quarter. Employer surveys are showing signs of softening labor demand in sectors where demand is sensitive to interest rates, like residential construction and durable goods manufacturing, but reduced hiring demand is not apparent in jobs data through July.
The US economy added 471,000 private nonfarm jobs in July, a big uptick from the nearly constant monthly rate of about 380,000 new jobs for the second quarter from April to June. Employment changes are on a seasonally adjusted basis.Monthly new job creation has been trending down since the first quarter of 2021, but job numbers for the second quarter and July are still strong more than one year later.
Employer surveys indicate a strong demand for labor, with 10.7 million job openings in June (the latest data month) and amounting to nearly two jobs per unemployed worker.Job Openings and Labor Turnover Survey, Bureau of Labor Statistics, July 6, 2022.
Job gains during the second quarter and July were balanced across all sectors of the national economy. Only the Leisure and Hospitality sector still employs significantly fewer people than before the COVID pandemic in 2020. By our estimate, 1.3 million fewer people were employed in Leisure and Hospitality in July than the pre-COVID expectation for that month, an employment shortfall of 7.1% for the sector.In previous issues of the QEB, we discussed employment consequences of the COVID recession in terms of employment gaps for different sectors. The employment gap is the difference between actual employment and an estimate of expected, pre-COVID employment including seasonal variation.
Education and Health Services is the only major sector other than Leisure and Hospitality for which private employment remains below its pre-COVID level, but with a national employment shortfall of only 0.4%. Job growth in this sector appears to be picking up in 2022. Education and Health Services is the second largest employer by headcount among all major sectors and added and about quarter million new private jobs during the second quarter and 122,000 more in July, placing first among all sectors and more than Construction and Manufacturing combined.
Professional, Business, and Other Services, a composite sector comprising services from accounting to lawn care, continues to create new jobs. Private employment growth was over 200,000 for the second quarter and a further 100,000 in July, second only to Education and Health Services. This sector is the largest employer by headcount among all major sectors and contains many small businesses and start-ups. Small businesses are more likely than large businesses to purchase workers compensation insurance rather than self-insure.
There are signs of softening demand in several sectors, especially those sensitive to interest rates such as new and rental housing, business investment, and durable manufactures. The Institute for Supply Management® Purchasing Managers Index® (PMI®) fell to 53 in June from 56 the previous month. The index for new orders dropped 6 points to 49, comparable to May 2020 just following the start of the COVID pandemic.Manufacturing ISM® Report on Business®, Institute for Supply Management®, June 2022. The PMI® is derived from survey responses. Above 50 is expansionary; below 50 is contractionary. Indicators for regional manufacturing activity in Texas and the Federal Reserve district for Philadelphia fell to their lowest levels since May 2020.
Wages. Wage growth has fallen behind the pace of CPI inflation since the fourth quarter of last year. The BLS index of hourly earnings for production and nonsupervisory workers rose 6.2% for the year ending in July, slowing to a 5.4% annualized rate in the second quarter and 4.9% for the month of July.
Because it surveys different pools of workers over time, the BLS wage index is subject to volatility that can impair its effectiveness as a measure of wage changes. The apparently big jump in wages during 2020 is actually an illusion resulting from massive layoffs during the first months of the COVID pandemic.Texas Manufacturing Outlook Survey, Federal Reserve Bank of Dallas, June 27,2022; Manufacturing Business Outlook Survey, Federal Reserve Bank of Philadelphia, June 2022. COVID-related layoffs disproportionately affected low-wage workers, pushing up average wages among workers still employed.Average Wages During the Coronavirus Pandemic, NCCI, October 30, 2020.
An alternate measure of wage change is the median change in hourly earnings at the beginning and end of the trailing 12 months for workers continuously employed during that period. The series for changes in hourly earnings among workers continuously employed shows an increase of 7.1% for 2022 through June, together with slower wage growth in the second half of 2021 and less volatility overall than its counterpart for unmatched worker pools.
In a wage-price spiral such as last occurred in the 1970s, wages keep pace with and also reinforce price inflation.For a short history of 1970s price inflation, including a picture of a young Donald Rumsfeld as director of the Cost of Living Council, see Echoes of the Wage-Price Spiral of the 1970s, The Wall Street Journal, February 11, 2022. That is not happening today. Pay increases accelerated beginning in the early part of 2021, but have consistently fallen short of increases in the CPI since then and appear to be plateauing in the second quarter of 2022. Workers are certainly better off than they would be without the bigger pay increases, but their purchasing power is being eroded by price inflation. This net result is a change in the price of labor relative to goods and services, not a wage-price spiral.
Price Inflation Consumer prices in the United States are rising faster now than in the last 50 years. The CPI increased by 9.1% for the 12 months ending in June, close to double the 5.4% rate of a year ago, and far above the pre-pandemic norm of 2% per year. The core CPI, excluding food and energy, rose 5.9% for the 12 months through June.The Fed most closely follows the core Personal Consumption Expenditure (PCE) Index but often refers to the core CPI in public statements. The two indices are similar but not identical, having different formulas, weights, and scopes. Differences Between the Consumer Price Index and the Personal Consumption Expenditures Price Index, US Bureau of Labor Statistics, May 2011. Like the core CPI, the core PCE excludes food and energy. Because food and energy prices are volatile, the Fed prefers to use core versions of the PCE and CPI as indicators for long-term inflationary trends.
Noncore CPI Inflation. Prices for food and energy typically fluctuate more than other CPI components, and are often separated out as noncore elements. Together, food and energy account for one-fifth of expenditures in the CPI basket of goods and services but contributed nearly half of the 9.1% CPI inflation for the year through June. In the past four months from February to June, CPI inflation accelerated to 13.9% annualized, with energy alone contributing nearly half.
Energy and food are examples of how price changes in specific markets can affect indices of price inflation, like the CPI. The reasons behind price increases for food and energy are complex. In both cases, they are a combination of long-standing supply and demand tensions being exacerbated by recent circumstances during and immediately after the COVID recession.
Energy prices, particularly for oil and natural gas, have their own story. Prices for oil and natural gas dropped precipitously in 2020 at the start of the COVID pandemic as businesses shut down and people stopped driving. But as demand began to recover strongly in the US beginning in the second half of 2020, prices for crude oil, natural gas, and refined petroleum products have risen rapidly.
As with many other industries, oil and gas production has been slow to restart following the COVID recession. Drilling and completion activities largely shut down during 2020 and are gradually re-ramping since then. Perhaps most importantly, demand for petroleum products rebounded more rapidly than expected (a common theme on earnings calls by oil producers and refiners). In addition, US shale plays are running short of attractive drilling acreage; drilling and completion costs are up, in part due to shortages of critical materials; and refining capacity is down due to closures since 2019.
Globally, food supplies have been declining relative to demand for years, pushing prices up. In the US, food prices have been more recently impacted by rising prices for inputs, including fertilizers and agricultural chemicals, brought about by supply chain disruptions and worsened by the Russia-Ukraine war.
Core CPI Inflation. After falling in the first year of the COVID recession, core CPI inflation (excluding food and energy) rose to 4.5% in June 2021. During the second quarter just ended, monthly readings for core CPI inflation ran around 6% per year, far above the Fed’s 2% long-term target but declining from the peak in March.
The recent fall-off of core CPI inflation is driven entirely by goods prices. A minor contributor to CPI inflation before 2020, goods prices spiked during 2021 as consumption shifted away from services and toward goods during the COVID pandemic. That shift is reversing in 2022, with the result that price increases for goods are slowing down.
Prices for services, including rent, grew less rapidly than those for goods through 2021 but gathered momentum steadily. Price increases for services including rent contributed 2.3% of 4.5% core CPI inflation in June 2021; they contributed 4.1% of 5.9% core CPI inflation last June.
Rental services accounted for 2.3% of core CPI inflation in June, and rising rent prices are unlikely to reverse soon. Rental prices lag housing prices by 16 to 18 months.Surging House Prices Expected to Propel Rent Increases, Push Up Inflation, Federal Reserve Bank of Dallas, August 24, 2021. Even if rising mortgage rates cool off housing prices, high rental price inflation is likely to be “baked in” to the core CPI through 2023.
Health Care Inflation. We address price inflation for health care services separately because of its special relevance to workers compensation.
To quantify health care inflation, we rely on the Producer Price Index (PPI) rather than the Consumer Price Index (CPI). While the CPI for health care services measures changes in the prices paid by consumers, the PPI for health care services tracks changes in the prices charged by producers. The two indices give very different measures of price inflation because consumers usually pay for only a portion of health care services, the remainder being covered by private or public health insurance. The PPI for health care services more closely corresponds to prices paid by insurers than the CPI for health care services and is a therefore a better indicator of medical price inflation in workers compensation.NCCI’s preferred metric for medical price inflation in workers compensation is derived from the Personal Health Care (PHC) index published by the Centers for Medicare and Medicaid Services. However, the PHC is only available by year whereas the PPI for health care services is updated monthly. The two indices are not identical but move similarly. In fact, the PHC index incorporates components of the PPI for health care services to measure price growth for physician and hospital services. These are the key components that we discuss here.
Inflation for health care services increased during the COVID pandemic much less than overall price inflation. For the past two years, price changes affecting components of the PPI health services index have been driven mostly by changes in rules governing Medicare reimbursement rates and eligible service venues.
Prices for physician services went up in 2021 when a temporary 3.75% increase in physician reimbursement rates under Medicare was approved as part of federal legislation aimed at providing COVID relief. Originally scheduled to expire at the end of 2021, the temporary increase in physician reimbursement rates was extended through 2022 at the reduced rate of 3%. Prices for physician services contributed substantially to medical inflation in 2021, but fell slightly in the first half of 2022.
The contribution of hospital services to health care inflation rose in the first half of 2022 due to price increases for outpatient services. Price growth for hospital inpatient services has stayed stable since 2019. However, the mix of inpatient and outpatient services has changed in the past couple of years. At the beginning of 2021, approximately 300 musculoskeletal-related services were removed from Medicare’s inpatient-only list, making them eligible for reimbursement on an outpatient basis. These services were later reinstated to the inpatient only list effective in 2022. The shift in price increases between inpatient and outpatient hospital services between 2021 and 2022 to date parallels the change in Medicare eligibility rules.
It is worth noting that the PPI surveys price changes for a broad universe of medical services, including those by group health and government-sponsored insurance. The rule changes discussed here affecting Medicare reimbursement rates and eligible service venues may have had a smaller impact on prices paid in workers compensation than on prices as reflected in the PPI.Medicare Fee Schedules and Workers Compensation in 2022, NCCI, April 4, 2022.
Looking ahead, the Centers for Medicare and Medicaid Services forecast medical prices to go up from 2% to 3% annually for the next several years, continuing but not accelerating the rate of medical price inflation since 2019. A different and bigger question relates to inflation in the total cost of delivering medical services. Changes in total expenditures for medical services depend not only on price inflation but also on changes in utilization, an additional dimension that goes beyond our focus on prices here.For an analysis of changing medical cost per claim in workers compensation that separates out the effects of price inflation and changes in utilization over time, see The Medical Dilemma, NCCI, May 11, 2022. This research finds that changes in per-claim medical expenditures over time are driven both by changing patterns of medical service utilization and by changes in their prices.
Does Inflation Now Foreshadow a Recession Next Year?
Micro-economic changes in relative prices versus macro-economic changes in price levels. In economics textbooks, price inflation is pure: a hypothetical ideal in which all prices increase uniformly, leaving relative prices among goods and services unaffected but eroding the value of money. In the real world, price inflation is not uniform. Price inflation in the United States today is largely driven by price increases for specific goods and services, among them energy, food, and housing.
The distinction between pure and real-world inflation matters for understanding inflation’s causes and the likely effectiveness of policy responses. Pure price inflation is a macro-economic phenomenon: it affects markets for all goods and services more or less uniformly, increasing the general price level but leaving relative prices unchanged. Pure price inflation is (theoretically) correctable by macro-policy responses aimed at restraining aggregate demand. In contrast, today’s price inflation is the cumulative effect of distinct micro-economic events: supply and demand dynamics producing non-uniform price increases that materially change relative prices for affected goods and services, while also affecting broad price indices like the CPI. Determining an appropriate macro-policy response—or whether such a response exists at all—is much more complicated for today’s micro-economic price inflation than the pure macro-economic idealization.
To illustrate the distinction, imagine that prices go up only for energy-related goods—gasoline, diesel, and jet fuels—while other prices remain stable. This is a change in relative prices: energy-related goods have become more expensive in relation to other goods and services. Relative price changes reequilibrate markets for specific goods and services in response to shifts in their supply or demand; in this sense they are micro-economic. Nonetheless, a big shift in relative prices for a major component of consumer spending can materially affect the CPI. In fact, price increases for energy and food alone accounted for more than one-third of CPI inflation for the current year ending in June, and almost half of CPI inflation since September of last year.
This contrasts with the textbook vision of macro-economic price inflation—a situation where prices go up more or less uniformly without materially changing relative prices. Today’s price inflation is far from uniform, being strongly concentrated in categories like energy, food, and housing.
The distinction between micro-economic price inflation—predominantly driven by changes in relative prices that manifest in indices like the CPI—and macro-economic price inflation—predominantly driven by global, across-the-board price increases that do not change relative prices— matters for two important and closely related reasons.
First, micro-economic price inflation is fundamentally an equilibrating response to shifting conditions of supply and demand among markets for different goods and services. Macro-economic price inflation is perceived mainly as the result of excess aggregate demand in the economy overall, not of supply-demand imbalances for specific goods and services. Second, the US Fed’s policy tools for interest rates are designed to counteract macro-economic price inflation, not the micro-economic variety.
How does Fed policy work, and what does it control? The US Federal Reserve has the dual mandate of controlling price inflation while also maintaining full employment.Full employment is common parlance. The Fed more specifically articulates its goal as maintaining the maximum employment level consistent with its targeted inflation goal of 2% per year. The Fed has historically associated maximum employment with an unemployment rate around 4%. In seeking to bring 12-month CPI inflation down from 9.1% to its long-term target of 2% by the end of 2024, the Fed will try to push up interest rates just enough to curtail aggregate demand and cut inflation, but not too much so as to push the US economy into a recession or prolonged slowdown. A smooth trajectory to an unemployment rate around 4% and price inflation of 2% per year by the end of 2024 is Fed Chair Jerome Powell’s vision of a “soft landing.” But many are skeptical that the Fed will be able to pull it off.Chair Powell’s press conference, US Federal Reserve, June 15, 2022; Summary of Economic Projections, US Federal Reserve, June 15. The Fed’s expectations laid out in June for paths of national output, unemployment rates, and prices in a “soft landing” scenario appear not to have changed in its July meeting.
The Fed’s main policy lever is the federal funds rate, the overnight lending rate to banks in the Federal Reserve system. Raising the federal funds rate pushes up yields at the front end (shorter maturities) of the yield curve. But the Fed does not directly control interest rates, especially longer maturities. Bond markets do that. What the Fed directly controls is the federal funds rate; it hopes that setting the federal funds rate higher or lower will influence other market-determined interest rates to shift correspondingly.
What exactly is the channel between interest rates and demand for goods and services? Not surprisingly, higher interest rates reduce demand for those goods whose demand is sensitive to interest rates. These include fixed investment by businesses and consumer purchases of houses and durable manufactured goods, like autos, which often are financed by borrowing. However, even these sensitivities can be overstated. For example, businesses that borrowed during the last several years at very low interest rates can use those proceeds to finance new capital investments today.
Equally obvious but often overlooked, higher interest rates have no effect on demand for products whose demand is not sensitive to interest rates. Consumption of nondurable goods and services—among them food and energy—are not sensitive to interest rates. People do take account of mortgage or financing rates when deciding to purchase a house or a new car, but not when they are buying groceries, using electricity, planning daily commuting or vacation travel. The Fed’s interest rate policy does not directly affect several of the demand components most responsible for current price inflation.
The Fed’s role in setting inflationary expectations. The Fed’s ability to control interest rates is limited, as is the ability of interest rates to regulate aggregate demand. We have argued that today’s inflation is not the textbook, macro-economic variety, but rather the result of micro-economic events in the aftermath of the COVID recession—big swings in demand for goods and services, labor shortages, supply chain disruptions. None of these are amenable to intermediation and control by the US Federal Reserve’s interest rate policies. The Fed itself is well aware of this point.“[O]ur objective really is to bring inflation down to 2 percent while the labor market remains strong. … [M]any factors that we don’t control are going to play a very significant role in deciding whether that’s possible or not. And there I’m thinking, of course, of commodity prices, the war in Ukraine, supply chain, things like that where we really … monetary policy stance doesn’t affect those things.” Chair Powell’s press conference, US Federal Reserve, June 15, 2022 (p. 13).
But the Fed also cares about expectations. In fact, influencing expectations is a critical part of Fed policy, arguably more important than changes that the Fed believes it can produce directly. By getting “out in front” of inflation with pro-active hikes to the federal funds rate, the Fed is seeking to convince the public that it will succeed in suppressing inflation and realizing a soft landing. If people believe that inflation will come down and that the economy is heading for a soft landing, then their own decisions for production, demand, and pricing will tend to realize those outcomes. Establishing the Fed’s authority and thereby “anchoring” public expectations for future price inflation was a recurrent theme in Fed Chair Jerome Powell’s June press conference announcing a 75-basis-point fed funds increase.In his June press conference, Powell referred several times to the Fed’s goal of “anchoring” public expectations for inflation: “Our overarching focus is using our tools to bring inflation back down to our 2 percent goal and to keep longer-term inflation expectations well anchored,” and, “One of the factors in our deciding to move ahead with 75 basis points today was what we saw in inflation expectations. We’re absolutely determined to keep them anchored at 2 percent.” Chair Powell’s press conference, US Federal Reserve, June 15, 2022 (p. 4 and p. 10).
The Fed’s situation today is not unlike that of Voltaire’s medical doctor, of whom the 18th century philosophe famously said, “The art of medicine consists in amusing the patient while nature cures the disease.” Lacking the ability to control demand, supply, and consequently prices in several markets driving today’s inflationary surge, the Fed’s role as inflation “doctor” is necessarily more indirect. Rather than “curing” inflation outright, two more realistic policy goals for the Fed are to restrain aggregate demand so as to minimize the chance that inflation will accelerate and to support long-term inflationary expectations in the neighborhood of its 2% annual target. Substituting “monetary policy” for “medicine,” and Fed Chair Powell’s phrasing about “anchoring” inflationary expectations for Voltaire’s “amusing the patient” makes the metaphoric correspondence explicit.
What’s worse: a short recession or a long slowdown? Assuming that there is a controllable trade-off between real GDP and inflation (a view that comes close to the idea of a Phillips curve), should the Fed be willing to weather a recession to realize 2% inflation, or should it tolerate higher inflation in the interest of not risking a recession? This question is at the heart of determining how aggressive the Fed will be—or ought to be. It is not possible to plot an analytic trade-off between inflation and economic growth, but orientation matters. One school of thought is that the Fed wants to get out front of inflation now by pushing up the federal funds rate, but will not mechanically raise the rate further if a recession seems imminent. Another school of thought thinks that it will, accepting a recession to squelch inflation if necessary. Uncertainty about what the Fed will do (or can do) creates uncertainty about whether inflation today portends a recession next year.
Focusing exclusively on recession overlooks a bigger question. Though not reflected in employment data for the first half of 2022, indicators including employer surveys, rising unemployment claims, and plateauing wage increases are signaling that the US economy is slowing down. Coming out of the post-COVID recovery, a slowdown is to be expected. The big question is how long and how deep will it be?
If we don’t get the soft landing that the Fed is targeting—a smooth glide to 2% annual growth in real GDP by the end of 2023—then in our opinion, the most likely bad-case scenario is for a prolonged and severe downturn, even if it does not include a recession.
In the scenarios shown above, a prolonged downturn could mean less than 1% annual growth in real gross domestic product (GDP) a year or more, say from the fourth quarter of 2022 through the first quarter of 2024.To give a sense of perspective, the most recent episodes of real GDP growth less than 1% for a full year are 2001 (the 9-11 attacks), 2008 and 2009 (the Great Recession), and 2020 (the COVID pandemic). A long downturn may not technically amount to a recession, but could easily be more severe than a brief recession followed by a rapid recovery. The big question is not whether we are headed for a recession per se (or whether the past two quarters can already be called a recession), but what a likely bad-case scenario for a future economic downturn looks like in terms of duration and severity and what might bring it about.
What might prolong and intensify an economic downturn, with or without a recession? In our view, the biggest single risk factor is not the side effects of the Fed’s interest rate interventions on the real economy, but the Russia-Ukraine war, now in its fifth month. The Russia-Ukraine war is disrupting global supplies and rearranging trading relationships. Some of the most consequential impacts are in foodstuffs, oil, and natural gas, commodities that already figure prominently among micro-markets having macro-effects. If the war continues through the winter into 2023, as appears likely, then disruptions to international markets for energy and food, part of an increasingly deliberate economic strategy by Russia, are likely to sustain and exacerbate the micro-economic dislocations driving price inflation and restraining real economic growth. A prolonged war in Ukraine will make the Fed’s soft landing more difficult, and economic dislocations from a long war are unlikely to be reversed by a short recession. A continuation of the Russia-Ukraine war through the coming winter increases the chance for a global economic downturn beginning sometime in the next six months and lasting through 2023.
What About Workers Compensation?
Price Inflation. Through midyear 2022, price inflation is having no material adverse impact on workers compensation. Essentially, two broad price categories are important for workers compensation: wages (the price of labor) and the price of health care services.
The COVID experience since 2020 affected employment and wages in unique ways, with initial job losses, subsequent job recovery, and wage increases disproportionately impacting low-wage workers in high-proximity service industries and occupations.The history of the COVID recession from the perspective of US labor markets is recounted in successive issues of the QEB beginning in the first quarter of 2020, and Is There a Labor Shortage? NCCI, August 11, 2021. To understand average wage anomalies during the COVID recession, see Average Wages During the Coronavirus Pandemic, NCCI, October 30, 2020. Indemnity benefits are tied to wages in most states, meaning that payments to injured workers go up when wages go up. Because workers compensation premium is directly written on payroll, in large part it adjusts automatically to wage changes for covered workers.As a rough estimate, wage-related indemnity payments constitute 40% of workers compensation benefits, with medical payments making up the remainder. In addition, NCCI’s ratemaking methods account for state-specific changes in coverage rules and benefit levels. Even during the extreme labor market upheavals of the COVID recession and recovery, NCCI’s recent research finds that disconnects between wages, indemnity benefits, and premiums have been minor and short-term.A detailed analysis of how nonuniform wage changes, such as those during the COVID recession and its recovery, affect indemnity benefits is in Why Wage Inflation Matters in Workers Comp, NCCI, May 26, 2022.
Workers compensation premium does not automatically adjust for changes in medical expenses, but price inflation for health care services is holding steady, not accelerating rapidly. Big price increases for energy, food, or rent push up the CPI, but do not directly affect covered losses under workers compensation. Recognizing that prices for most insured medical services are negotiated in advance, usually on a calendar-year basis, it may be that general price inflation will get passed on into higher medical price inflation in the next couple of years. Medical price inflation may pick up more sharply in the future, but that has not happened to date.
Downturn or Recession. In a future economic downturn or recession, the main effect on workers compensation is also the most obvious: falling employment in a downturn cuts workers compensation premium; rising employment in a recovery boosts premium. The primary channel affecting premium is employment itself; another channel is via wages. Wages, or at least wage growth rates, typically fall at the beginning of a downturn and rise during its recovery. The apparently opposite effect during the COVID recession—average wages went up in 2020 just after the pandemic hit—came about not because workers were getting bigger pay increases, but because layoffs were heavily concentrated among low-wage workers.
Because payroll is the product of employment and wages, using payroll as an exposure base buffers workers compensation premium for changes in both, keeping premiums largely aligned with indemnity benefits linked to employment and wages.
Downturns and recessions also affect injury frequency. Injury frequency tends to fall when employment drops during a downturn or recession, rising again in a recovery. One explanation for cyclical variation in injury frequency relates to changes in the mix of short-tenured versus full-tenured workers. Short-tenured workers tend to get laid off first at the beginning of a recession and rehired last during a recovery; and short-tenured workers have higher injury rates than full-tenured workers.How Do Recessions Affect Workers Compensation?, NCCI, October 16, 2019.
The COVID pandemic in the United States caused massive job losses in the spring of 2020. Since then, employment recovery has been remarkably rapid. The magnitude of the employment swings during the past two years, including movement of workers across jobs, industries, and occupations—the Great Reshuffle—increased the share of short-tenured workers in many sectors of the US economy. Even so, NCCI’s research finds only minor frequency impacts from increases in short-tenured workers by industry sector; and these tend to average out in aggregate ratemaking as a result of employment shifts across sectors.The Great Reshuffle In Labor Markets, NCCI, May 10, 2022.
A takeaway from the preceding discussion is that a downturn or recession mainly affects workers compensation through employment. The scale of workers compensation underwriting in terms of either total premium or paid benefits rises or falls with the level of employment. Other effects via wage changes and cyclical variations in injury frequency also matter, but based on past experience including the COVID recession, their impacts are of secondary magnitude.