A tale of two shocks, part 2
The paradox of full-employment stagnation
The demographic shift we discussed in part one of this series will continue to constrain the size of the workforce from here. In our view, the workforce will grow by only 0.5% on average each year, compared to 1.5% before the pandemic.1
Demographics mean big structural adjustment
This will entail a big change in growth and jobs trends. But the structural adjustment goes much wider than that. Unlike a wave of growth in a typical business cycle – that brings all boats up and down with it – this structural adjustment will mean big changes in income and spending mixes and in interest rates.
Growth. A smaller workforce means the rate of growth the economy will be able to sustain without resurgent inflation will be lower: more like 1% than the 2% we were used to, we think.
Jobs. Before the pandemic, nearly 200,000 jobs were added each month without stoking inflation. We think this demographic shift means the economy will soon only be able to sustain around 70,000 additional jobs each month to avoid ever-growing pressure on the labor market and wages rising unsustainably quickly.
Labor income and profit mix. The structural shift goes deeper than its effects on overall growth, we think. More scarce labor means more bargaining power for workers. And that should lead to a shift in how all the income generated in the economy is being distributed: a greater share is ending up in employees’ pockets and a smaller share for companies and their shareholders. More pay, less profit. The labor share of national income is set to rise from its currently historically low levels. See Chart 1.
Mix of spending. With a bigger share of income ending up with workers, we expect consumer spending to be more resilient than the wider economy. The associated squeeze on profits could hold back business investment. There are signs of that already in the way the economy is evolving. Indicators of consumer confidence are holding up well compared to broader indicators of economic performance, as the orange line in Chart 2 shows. Consumer spending has been supported by fast-rising wages as well as the excess savings many were able to build up during the pandemic. And – in a stark divergence from other economic indicators – consumer confidence remains pretty buoyant, per the yellow line in Chart 2. We think that relative strength will continue as employees take home a greater share of national income.
Interest rates. The new lower growth equilibrium could eventually lead to a lower interest rate environment. But only after a period of high interest rates has helped the economy to weaker growth of production capacity. People will need to save more and spend less to avoid the economy overheating. But aging tends to come with more non-discretionary spending – or expenses that are more necessity than choice – and high levels of government debt. So, many years of high interest rates will likely be needed to resolve these pressures.
In such an unprecedented environment, many outcomes are possible. We’ll keep assessing how the mismatch and demographic shocks are playing out.
Outlook for the coming year
At this stage, our assessment is that we are set for “full-employment stagnation.” Most of the inflation and wage growth we’ve seen to date reflects the mismatch associated with pandemic. That is now reversing well and inflation is set to fall further. But as the process of resolving the mismatch ends and labor shortages start to bind, we expect inflation to go on a rollercoaster ride, rising again in 2024.
We had expected a mild recession ahead as the Fed’s rate hikes weighed on the economy. But with growth up to now weaker than we thought, some of that effect seems to have already occurred. Our base case is that the economy broadly flatlines for another year as the full impact of high interest rates comes through and consumers exhaust their pandemic savings.
If that’s right, the economy will have flatlined for two and a half years in total. That would be the weakest such period in the post-war era outside the Global Financial Crisis. And yet the Fed, far from coming to the rescue from such weak growth performance as it did in 2008, has kept hiking to stop the economy overheating. This illustrates that the economy is undergoing a big structural shift and not a classic business cycle.
There is another possibility that we’ll be watching closely: resurgent growth. There are some signs that growth is picking up, though the picture is confused by the divergence of the consumer from the broader economy. What if growth does accelerate from here? In a normal cycle, after a period of weakness, this might be seen as good news. But in the context of a big structural shift it has important – different – consequences.
It would quickly put pressure on the labor market, amplifying the upswing in the inflation rollercoaster next year. Employment already needs to slow sharply to avoid too much pressure on the labor market, and stronger growth would make that nigh on impossible. As Fed Chair Powell said: “Reducing inflation is likely to require a period of below-trend growth.” A reacceleration would tell the Fed that its current policy isn’t restricting the economy as much as it thought. So, it would likely respond by raising rates further, and keeping them there for longer.
That wouldn’t be a soft landing. And that’s why we can’t look at the normal indicators of consumer strength and the labor market to assess the path ahead. The only way to have resurgent growth without these side effects would be if it came alongside a rapid rise in productivity, effectively negating the worker shortage by allowing output per worker to increase more rapidly.
Our bottom line: this is not a business cycle. We are in the midst of a structural shift. Monetary policy cannot rescue the economy from weakness. The Fed will need to make sure the U.S. economy is not growing more quickly than what it can now maintain without inflation surging.
1. Based on projections of how population size and structure will evolve and assuming inward migration flows rebuild to their pre-pandemic rate.
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