· The seeming contradiction between a strong labor market, high inflation, and weak sentiment is easily explained by a potential growth rate below zero and monetary policy that remains stimulative. Any growth will be highly inflationary because actual output is above potential output.
· Only a reduction of demand below potential will cool output, but the current situation differs from so-called “soft landings” where the growth rate has exceeded the potential rate and the economy can rebalance without shrinking just by slowing down.
· A neutral stance to monetary policy would result in conditions normally associated with a recession. Given the FOMC committed to moving itself to a restrictive stance in the immediate future, the economy is likely in for a bumpy ride as the Fed triggers a worse recession than it expects and is quickly forced to retreat.
The Employment Situation Report for June added to the confusion among market commentators debating on whether the U.S. is entering a recession or not. By all signs this writer knows of, the labor market is “strong” but GDP forecasts are increasingly indicating negative growth and consumer sentiment is intensely depressed. Understanding that seeming contradiction, easily explained by “neutral” interest rates and potential growth rates, are the topic of this note.
Labor Demand is Red Hot
As mentioned above, signs that employers are desperate to find enough workers to maximize return on fixed capital are easy to find these days. The Beveridge Curve is indicating very strong demand and, fortunately, that the disruption caused by the pandemic did not permanently damage the matching efficiency of the U.S labor market (Chart 1). The strength of demand is clear to see in the number of job openings employers are reporting to the Bureau of Labor Statistics (Chart 2). However, at such a low rate of unemployment, additional demand for workers has simply inflation in the costs of finding and hiring new workers. Indeed, the producer price index for Employment Services (i.e. “headhunters”) is rising well above the rate normally seen during periods of full employment and the trend points clearly to further acceleration (Charts 3 & 4).
Labor Supply is Not
Unfortunately, all this labor demand comes after a long period of diminishing labor supply that was only made worse by the pandemic (Charts 5 & 6). Indeed, the pandemic likely accelerated retirements by two years and left many with college degrees questioning the value of working. The result is that, unless some political or cultural factor shift occurs, the participation rate is unlikely to recover to its pre-pandemic level above 63% until Father Time carries away the Baby Boomers and the age distribution normalizes. For the time being, the labor force has literally run out of workers and only an increase in productivity or a reduction in demand can tame the inflation beast.
As per the usual, market commentators completely missed the most important statement in the minutes from the FOMC’s meeting in June. I discussed the topic in my latest Weekly Beat, but the statement is worth revisiting here. From the Staff Economic Outlook section of the minutes (emphasis added): “The level of real GDP was still expected to remain well above potential over the projection period, though the gap was projected to narrow significantly this year and to narrow a little further next year.”
The implications of that statement are huge because it means, in the eyes of the Fed’s economists, the normal growth rate is below zero. Thus, a neutral stance to monetary policy would result in conditions normally associated with a recession. Given the FOMC committed to moving itself to a restrictive stance in the immediate future, the economy is likely in for a bumpy ride as the Fed triggers a worse recession than it expects and is quickly forced to retreat.
Of course, this is a crisis that has been brewing for a long time and it is the sudden unexpected strain of the pandemic and ill-informed government responses that are bringing the problem to a head. The participation rate in the United States has been trending down for more then two decades and the potential growth rate has been coming down with it (Chart 7). It has only been the brief mania of asset bubbles that allowed the fantasy of a higher potential growth rate to persist.
As discussed in my note “For What It’s Worth: The Vietnam War and The Great Recession” of 6 July 2019, the U.S. economy had for decades been producing far too many college degree holders looking for white collar jobs and far too few workers with a high school graduation and vocational training. That problem was kept in balance by a steady growth rate and slow decline in participation. However, a sharp drop in participation among workers without a college degree followed the initial pandemic lockdowns that has yet to reverse (Chart 8). The sudden change in the supply of low skill workers threw the labor market into a disequilibrium that is still being resolved.
Conclusion
The seeming contradiction between a strong labor market, high inflation, and weak sentiment is easily explained by a potential growth rate below zero and monetary policy that remains stimulative. Any growth will be highly inflationary because actual output is above potential output. The reason this has occurred is because labor force participation deteriorated suddenly during the pandemic and the mix of workers in the economy post-pandemic does not fit well with the mix of pre-pandemic capital goods that are in place. Only a reduction of demand below potential will cool output, but the current situation differs from so-called “soft landings” where the growth rate has exceeded the potential rate and the economy can rebalance without shrinking just by slowing down. In the current situation the absolute size of the economy is too large and therefore an actual shrinkage must occur for rebalancing.
Related Notes
The Underpinnings of a Nonlinear Phillips Curve
U.S. Labor Market: The Fed’s Participation Dilemma
Growth Cycles and Turning Points
If a worker's wages don't cover child care for their 1.4 kids (the 0.4 kid is seriously ugly), never mind covering maintaining an fueling the aging minivan for a daily commute then why bother? Family unit is probably better off as a whole if one parent stays home for the urchins and maybe learns how to garden or something else actually useful and productive. Before my mother passed away we took a road trip to where she grew up and she talked about how hard those days were and how self-sufficient every family had to be whether they were townies or hayseeds. I laugh when I hear media droids drone on about the wonders of working from home. There used to be a name for that form of working, although it often just amounted to isolated out-of-sight servitude for the low-skilled, they called it "cottage industry." Those workers and that economic model was crucial in the US during WWII because that was where the necessary highly skilled machinists worked to a large degree (ahhh, the wonders of electricity to every home...). The idea of bringing highly skilled technical workers like that into a central location (like Ford had done with low-skilled assembly line men) was still a novel idea. I had a relative that used to make various high precision parts for aircraft out of his 'garage' during WWII and right up into the Vietnam madness. Then there was their contribution to centuries of English industrial development. An untold and unappreciated story by most of the stunningly ignorant OECD citizenry is the extent to which China bootstrapped itself on the backs of similar small-shop/home technical/machinist 'cottage' workers. Memories of the extreme sacrifices these workers and families suffered to advance China are no doubt still pretty fresh in living memories still. I suppose it must play into the extreme irritation Chinese officials demonstrate today when some Western ignoramus presumes to scold them for this or that 'human rights' abuse. Must be pretty galling to listen to that crap when millions of your people sacrificed themselves to feed OECD supply chains with the least expensive inputs possible. Have to imagine this model is still important in eastern Europe and places like Ukraine. Many of the Chinese workers responsible for the China economic 'miracle' died early, but, I'd imagine there are large pockets of them still laboring in conditions hard to imagine. All this is likely just a long winded way of saying maybe those lines on the graph, hinting at a labor supply/demand gap not seen since the 1950's in the USA, are marking less of a return to a relatively recent past and maybe are symptomatic of a possible reversion to something so old it is new again? When 'progress' stops the past catches up.