· The supply of non-college degree holders in the labor force has been shrinking in relative terms but could soon begin shrinking in absolute terms as well
· Demand for labor is very high but unless additional labor is forthcoming potential growth will be very low, perhaps negative. The temptation for the Fed will be to “pause” monetary policy, but the inflation reprieve is a Trojan Horse for a wage-price spiral.
· The U.S. faces a labor force composition problem that can only be solved by improving labor participation, encouraging immigration, or raising interest rates to free resources for productivity-enhancing investments.
Employment growth continued at a “strong” pace in May, but there is no denying the trend of slowing employment growth in the data (Chart 1). The revision-driven increase in January sticks out like a sore thumb amid the trend decline, implying two potential scenarios. Unfortunately for the Fed, the scenarios have vastly different implications for inflation and growth with differing monetary policy responses. This note examines potential outcomes in the U.S. labor market in the second half of 2022 and the implications for growth and monetary policy.
The first possibility is that employment is still being undercounted. I wrote in February 2022[1], shortly after the January data had been revised, that Fed policymakers made the same mistake in 2021 that they had in 2003 – not accounting for procyclical measurement errors in employment growth when making policy decisions. The revision made clear why the economy did not run out of steam in 2021, because more workers existed than the Bureau of Labor Statistics initially estimated. The same procyclical error could still be occurring. As will be discussed below, indications of demand for labor remain strong.
The second, more disturbing, possibility is that labor force participation has continued the downward trend in place since 2000. That possibility implies the new “peak” in the employment ratio will be lower than the one seen prior to the Great Recession, and possibly even the ratio seen in 2019 (Chart 2). Indeed, the size of the labor force had been growing until it reached the size observed just as the COVID crisis hit (Chart 3).
Whether the pause in labor force growth at that point is coincidental or the sign of a structural top remains to be seen. What is clear is that slower growth and a lower employment ratio go together (Chart 4). Volumes have been written debating in which direction causality runs, but the link itself is more important for investors than the direction of causality. Unless trend growth and the employment ratio improve, we should expect either lower growth or higher (and steadily rising) inflation.
Participation Nation
The decline in labor force participation over the past twenty years is not news, but the strength of the labor market in 2019 had raised hopes that the trend might reverse or at least flatten out (Chart 5). More than two years have passed since the COVID crisis hit the U.S. labor market, trillions of dollars of fiscal and monetary stimulus have been unleashed and nominal wages are rising rapidly. If the labor market ever had the wind at its back, that time would be the past twelve months. However, despite all the help, the participation rates for men and women remain 1.5 percentage points below pre-COVID levels (Chart 6).
Notably, the participation rate for both sexes is down by approximately 1.5 percentage points across levels of educational attainment (Charts 7 & 8). The similarity in participation developments across a broad variety of groups suggests large-scale behavioral changes, rather than a temporary disturbance caused by specific circumstances. If the change in participation is a long-term change in preferences, then accelerating wage growth will likely need to accelerate further and continue for an extended period before nonparticipants are drawn back into the labor force.
In fact, as was the case with the decline in manufacturing employment, workers who were pushed out of the labor market by industry disruption tend to stay out. Note that the workers driving the return to the labor force are women ages 25-44 and men ages 25-34 (Charts 9 & 10). Older workers are showing signs of settling into a lower participation rate.
The Reverse Skills Gap
As discussed in my note on student loans, the U.S. government created an education-industrial complex based on the assumption that a college degree was an automatic ticket to the middle class. The result was an ever-growing supply of college graduates with diplomas of dubious value. Indeed, over the past decade the population of college graduates over twenty-five years old has grown by forty percent while all other categories were stagnant or shrank (Chart 11). If we make the very generous assumption that on average college graduates have more valuable skillsets than non-college graduates, then we still do not avoid the problem facing the U.S. economy and the primary obstacle to the Fed’s efforts to engineer a soft landing. Unless the productivity of non-college graduates has increased greatly or college graduates can do the jobs of non-college graduates at higher productivity rates for higher pay, then the labor force is mismatched to the needs of employers. Plain and simple, there are too many college graduates relative to the population of non-college graduates. Worse still, the labor force has aged notably, and a much higher percentage of younger workers are college educated than their older peers (Chart 12). As a result, the supply of non-college degree holders in the labor force has been shrinking in relative terms but could soon begin shrinking in absolute terms as well (Charts 13 & 14).
The results of the reverse skills gap in the labor market, which was exacerbated by COVID not caused by it, are readily apparent in wage data. The Atlanta Fed Wage Tracker takes the usual wage survey and excludes anyone who was not employed one year ago, so it provides insight into the experience of an established worker with stable employment opportunities. Currently, the Atlanta Fed’s wage tracker registers nominal wage growth at peak levels in data going back to the 1980s (Chart 15). The problem with that outcome is that productivity is not growing at rates seen during the digitalization of the 1980s and 1990s. The result is that nominal wage growth is being converted into inflation and real wage growth has been negative for many workers.
Although the employment ratio for workers without a college degree is lower than it was pre-COVID, wages for low-skill occupations are currently growing faster than those for more skilled jobs, indicating a shortage (Charts 16 & 17). The shortage of unskilled adults has led to a bidding war for teenaged workers, whose wages are accelerating at a frightening pace (Chart 18). The Fed will continue to face inflationary pressure until we see a turn in this measure.
Dangerous Curves Ahead
The purpose of inventory is to smooth out the short-run supply curve because, obviously, the marginal cost of literally producing everything on-demand would be prohibitively high. That means the inventory slows down prices changes in the spot market by allowing production adjustments to occur over time via changes in future orders. The upshot is that when inventory runs low, price changes become much more volatile. The same mechanics of supply and demand are at work in the labor market, and indications are that demand remains high while inventory is very low. Indeed, the acceleration in wage growth relative to the bottoming of the non-employment rate has traced out a Phillips Curve that is near-vertical (Charts 19 & 20). A vertical “curve” means that no matter how much employers bid up wages they cannot all satisfy their demand for labor. That is a recipe for the wage-price cycle the Fed so fears.
The Beveridge Curve provides an indication of demand for labor and the ability of the labor market to match employers with job seekers. The initial shock of the COVID shutdowns was that matching efficiency dropped significantly, causing the Beveridge Curve to shift dramatically to the right. Since then, the curve has migrated leftward back to its original position (Chart 21). That is an encouraging sign because it means that even with all the quitting and moving, the matching efficiency of the labor market has fully recovered. We also know, based job openings, that demand for labor is very high. Indeed, employers are willing to post a massive number of job openings for a relatively modest payoff in terms of faster hiring (Chart 22).
Further confirmation of strong employer demand for labor comes from the producer price index reading for employment services (i.e. headhunters). The cost to firms of hiring experts in finding employees has exploded above boom rates going back to the 1990s (Chart 23). Indeed, it remains to be seen whether we have seen the top in price growth for this service, given the spike seen in March (Chart 24). Employers are desperate for labor to turn inventories into finished product before demand conditions sour and firms take losses because their Cost of Goods Sold will soon be rising as they work their way into inputs bought at inflationary prices. That is a bad situation for the Fed and is a classic symptom of a Hayekian cycle.
Deus Ex Machina
As mentioned above, there are only two solutions to this problem. Either non-participants enter the labor force, and the participation rate rises, or machines are installed to make the remaining workers more productive than before. The prospects for getting workers back into the labor force is decidedly mixed. Among adults over twenty-five years, the percentage of non-participants who would like to get a job but are discouraged or otherwise prevented from getting one has effectively returned to its pre-COVID low (Chart 33). Thus, it will take a major change of heart to get loads of prime-age workers back to the labor force.
For people aged sixteen to twenty-four there is some potential room for improvement in labor force participation. Indeed, the participation of high school students in the labor force fell to an atrocious twenty percent prior to COVID (Chart 34). Full-time college students also reduce their labor force participation in the decades leading up to the pandemic. Perhaps an ending of the human capital bubble caused by government loans to students could encourage more high school students to get a part-time job in preparation for entering the workforce without wasting time in college.
Other indicators this writer will be watching for signs of return to “normality” are employment in Child Daycare service and at online retailers (Charts 35 & 36). Employment in the daycare industry continues to grow but has yet to reach pre-COVID levels. If the problem is one of supply, parents cannot go back to the office until their kids are being looked after. Alternatively, parents not going back to the labor force will have no need for daycare. Along the same line of reasoning, employment at online retailers has stopped growing after rocketing higher for two years. That could imply patterns of demand are normalizing, or it could mean these businesses are unable to find enough employees. This writer will be watching these and other key measures closely in coming months for indications of labor supply.
Conclusion
Conditions in the labor market are putting the Fed in a very difficult position. Firms are still working to rebuild their workforces after the COVID shock, and many are struggling to right-size their capital-labor ratio. Thus, demand for labor is very high but unless such labor is forthcoming potential growth will be very low, perhaps negative. The temptation for the Fed will be to “pause” monetary policy in response to slower-than-expected economic growth. However, continued wage growth pressure in the absence of rapid productivity growth will cause the threat of inflation to loom larger and larger for the Fed.
This writer is expecting that a short-term relief in inflationary pressure and a slowdown in growth to a lower potential growth rate will indeed tempt the Fed into a pause later this year. However, the result will be that the inflationary momentum that is built up in the labor market will cause another surge in inflation to occur and force the Fed to turn hawkish again. The U.S. faces a labor force composition problem that can only be solved by either improving labor force participation, encouraging immigration, or raising interest rates to free the resources needed to make productivity-enhancing investments so that firms can make the most of the workers that are available. Until such a solution occurs, all monetary policy will do is bounce the economy between overheating and recession.
[1] See my note “Employment, Inflation, and Policy Errors – They Did It Again” of 20 February 2022.