How Is The Labor Market Impacting Inflation?

Transcript

Jean: We think that if central banks are to bring inflation back to 2% very quickly we’re seeing the need for at least 3 million jobs to be disappearing in order to bring inflation quickly back to 2%.

Oscar: Welcome to The Bid, where we break down what’s happening in the markets and explore the forces, changing the economy and finance. I’m your host Oscar Pulido.

The U.S. Economy has reopened post COVID-19 pandemic. U.S. unemployment rates remain at historically low. But because of the pandemic, we’ve seen a large fraction of the labor force that remains on the sidelines with the Fed aggressively raising interest rates in an effort to reduce inflation.

What impact will this have on the labor market going forward? To help me answer that question, I’m pleased to welcome Jean Boivin, Head of the BlackRock Investment Institute. Welcome Jean.

Jean: Hi Oscar, great to be here.

Oscar: Jean, can you give me an overview of how the labor market has been doing over the last couple of years and where is it now?

Jean: So I think the first point I would make at the outset is we are facing a very unusual labor market dynamic at this juncture. And the typical playbook of how you’re thinking about the labor market in the recession and then the recovery is not useful. The key unusual feature is we’ve seen a story that was mostly about the labor supply but typically when you go to an expansion in a recession, most of the action comes from companies’ demand for labors.

If in expansion they’re gonna go heavy in the labor market, demand more, that’s gonna drive down the unemployment. And when things go bad, recession, they’re gonna lay off people. And then the demand pulling back is what leads to the fluctuation in the labor market.

This time it’s really driven by the labor supply. So because of the pandemic we’ve seen a large fraction of the labor force that has for whatever reason, decided to stay on the side of the labor market.

The big constraint here is really that we have difficulty to bring people back to work. There could be demographics, various reasons, aging and so on, but there’s also the time it takes for people to reengage with the labor market after having stopped the economy like we’ve never done before.

So key point here is the dynamic of the last couple of years is really a labor supply story like we haven’t really seen before that hasn’t normalized yet and as a result this is very unusual.

The other layer which is also adding to this labor supply story is that we have seen over the course of the pandemic, the biggest sectoral reallocation on record, we went massively away from services to goods.

It goes beneath that rather more granular sectors. And that has led to a very significant mismatch between the type of skills that the employers are looking for in different sectors and the employees available.

So it’s not only an aggregate labor supply story, but it’s also allocating that labor supply now is much more difficult than it used to be and it creates these bottlenecks, these matching issues that we’re seeing in the labor market. So again, key point is this is really a labor supply story.

Oscar: Okay. So now that we know what’s happening in the labor markets, let’s try and connect the dots. How does that tie into inflation?

Jean: Well, this is very important because the diagnostic on where you think the labor market is and why leads you to different implications about how it’s gonna map into inflation.

So a big question thinking about the inflation outlook is whether this participation that we’ve seen declining very massively over the course of the pandemic will come back. We don’t think all of it will come back, as I mentioned, there’s demographics aging population that has been part of that story and there’s stories about the pandemic accelerating those decisions toward retirement, this is part of it. But that explains about half of the shortfall that we would have expected to recover since the pandemic and still hasn’t.

So I think there’s hope for some more labor participation to pick up. And if it happens, it’s gonna ease some of the labor market pressure and that’s gonna help to bring inflation down.

But it’s not the entire story and it won’t be covered entirely but the key point is as long as the labor supply is the limiting factor, unless easing factors come into play, that will eventually lead to wage pressures and could be a risk to provide even more inflation push than we have seen up to now.

I think it’s important to note that the labor market, despite all of the attention that we had on it by policy makers, market participants, and so on, the fact that there’s a lot of questions about this unusual behavior, we haven’t seen yet wage pick up to an extent that it is part of the current inflation story, so I said it could become, but it hasn’t yet. So that’s an important part to watch and will be a key factor determining the policy stance of central banks over the course of the next few months.

Oscar: So the labor market is tight, meaning unemployment is low. And while that has led to higher wages, you’re saying it hasn’t really been the cause of higher inflation. So what would have to change for companies to start increasing wages at a rate that does start to impact inflation?

Jean: So we’re seeing here it takes longer for firms to fill jobs economists like to talk about something called the Beveridge curve, this is really about the relationship between the job posting vacancies in relation to the level of unemployment that you see, you would tend to think that the lower unemployment rate, the shorter posting would be, it would go faster to fill vacancies if we have a very tight labor market.

It turns out that this relationship has been broken during COVID, what we are saying is that despite the very low unemployment rate we’re seeing job posting being at an unusually high level. So it takes longer for firms to fill jobs. I think it speaks to this big sectoral reallocation story that I’ve talked about.

I think that sectoral reallocation has affected maybe the lower skill part of the employment and of the labor supply, which takes longer to be reallocated or find jobs in other sectors. It takes longer for firms to be convinced by the fact that they found the right employees and so on.

So that explains the down correlation in the relationship, the fact that it takes longer to fill jobs than it used to, but the reality is there’s more competition for the pool of workers that is available, and that is more restrained than it used to be.

And over time that is gonna put some pressure on wages, and we’re seeing nominal wage growth has been picking up, has been pretty strong. In fact, we see ample evidence that this is also adding to people trying to quit and move out of their job, creating some vacancies, because one way to bid up your salary is actually to change jobs rather than staying in the job.

So there’s been some incentive to do that. So this is a mix that eventually could lead to wage pressure that will then translate into more inflation, but it’s important to acknowledge though that at this point it hasn’t been the case and the reason is that firms have been able to raise the price of the things they sell faster than the wage that they’re paying to their employee.

So despite the fact that we have a tight labor market, we are seeing wages going up but real wages, adjusted for inflation have been falling. So that’s why it’s not yet affecting the company’s bottom line, it’s not creating an incentive for the firm to raise prices even faster to cover their wage bill because their wage bill in real terms hasn’t really increased yet, and that has been the story so far, but that’s the thing that could change if the tightness of the labor market persists.

Oscar: So Jean, what you’re saying is, there are more jobs on the market, there are simply fewer people to fill those jobs, and thus far wages are not going up as much as the cost of living is going up?

Jean: Absolutely these are the three facts I’ve put on the table here. And right now it creates a bit of a conundrum. We talk about a very tight labor market it creates some concern. People are linking that to inflation, but it hasn’t been the story of inflation yet, it could become, but it hasn’t been yet.

Oscar: Recently Fed chairman, Jerome Powell has come out and said that the US labor market is hot to an unhealthy degree. Help me understand if labor markets are growing. Why is that so bad for the economy?

Jean: I need to start by taking a different perspective on the characterization of the labor market the word, the use of the word very hot I think there’s a risk here, I cannot speak for the Fed, but to me, it sounds as applying the old playbook of the labor market in a typical business cycle.

And when you see these kinds of low unemployment rates, the kind of vacancies we’re seeing, typically it has been a sign of a very hot, unhealthy labor market. That’s true when this is all driven by companies pushing hard on the labor market because demand of consumers and so on is exuberant. That’s not the situation here. As I said, it’s the scarcity in the labor market is coming from not enough workers as opposed to too much demand for workers.

And so that is very different. I think “hot and unhealthy” conveys there’s too much of it. The fact is that there’s too little. There’s too little of labor available to work. Very different from what used to be called a very hot labor market. So I agree with you, it’s odd to say that when in fact we would like to have more people working but again we are used to see a world that is very driven by the demand side, whereas this.

Time is really driven by the supply side and the kind of frame wording template playbook we use don’t necessarily translate as easily to characterize the current situation. So bottom line is I don’t see the current labor market as being “hot, unhealthy” this is really about bringing more people to the labor force helping a more smooth reallocation of workers across sectors to unplug these bottlenecks that are characterizing the labor market at this stage.

Oscar: So if current unemployment levels are not sustainable at the moment, and you start to get more people back into the labor force, what is that level of unemployment that would be consistent with more stable wage growth and more stable inflation?

Jean: So I think we need to embrace the fact that we will likely have to see some increase in the unemployment rate from the low levels we’re seeing here.

That’s gonna happen normally as more people come to work the demand and the restart of the economy starts to cool off. We’re gonna stabilize at a rate of unemployment is gonna be somewhat higher than where we are now. I don’t think the unemployment rate that we have now needs to be compared historically to the same level, which were very hot labor markets.

So I think we, we don’t wanna do this translation or this comparison, but at the same time even if it’s not hot per se it’s not necessarily unhealthy because that’s part of restarting.

It’s not the level that I would expect to be sustained over time. So I think we’re gonna be in a world that’s gonna get closer to 5% over time. I think this is the natural level that a US economy has been operating will continue to operate after things settle.

It doesn’t mean that this three-ish numbers we’re seeing now is unhealthy. I think it’s part of the adjustment we’re going through it is. Not the same 3% as we would’ve seen in the past or 3.5, 3.9, but it’s gonna be up from here to some extent however that’s gonna also depend on what central banks decide to do and how they interpret this world.

We think that this is a world again, it’s very different from what we’ve seen over the last 40 years we think the Great Moderation, what’s the characteristic of the last forty years is over and as a result, central banks are facing a much more severe choice between either the stabilized inflation or the stabilized growth.

I don’t think they can have both anymore because this is a world where the main driver is production constraints of many sorts.

So given the sharper choice central banks we’ll have to decide whether we live with somewhat more inflation or we insist on bringing inflation back to 2% quickly.

We think that if central banks are to bring inflation back to 2% very quickly that’s gonna come at a very important cost, we don’t think this is the best outcome necessarily for society, and in that case, you could see unemployment going to above 5%, we’re seeing need for at least 3 million jobs to be disappearing in order to bring inflation quickly back to 2%. I think the economy can operate at a lower level, maybe five. But if we insist on bringing inflation quickly back to 2%, then we’ll have to accept higher employment rate than that.

Oscar: So John, I think you’ve touched on this, but it sounds like what’s happening to the labor market now is, is not something that we necessarily see very often, but, but rather a symptom of a broader phenomenon. Is that the right way to think about it?

Jean: I, yes, I think the answer is yes. And I talked about this being an unusual labor market dynamic this time being driven by the labor supply as a key constraint.

There is a longer-term structural story that is going on here. These, this is a manifestation of a limitation to production to the ability to produce. So the labor supply labor market is one of the bottlenecks we’re facing.

There’s actually a few more of those restarting the economy has been difficult, and we haven’t managed to yet go back really to the level we were able to sustain before the pandemic in large part because of the bottleneck that the labor market is representing.

But there’s more it’s, we still have supply chains issues that needs to be resolved. And I think we’ve learned through COVID that, the global economy is a pretty well tuned complex network, which was working fine and had not been disrupted too much.

But I think now that we’ve disrupted it, we’ve learned that it’s a very complex network that is subject to the weakest link. Right now, the labor market is one of the weakest link holding back the entire supply chain, but it’s true more broadly.

This is also longer-term issues. Demographics has been one of the reasons why labor supply is so low is something that we knew for a long time. The easiest thing to forecast 20 years in advance is demographics. Because you pretty much know who has been born and who was gonna be there in 20 years.

So that demographic is not news, but now we’re seeing that being like a driver at this stage and a key limiting factor. You add that to other longer-term phenomenon, the rewiring of globalization that is happening accelerated by COVID and you also have the climate transition.

These are all things that have something in common, which is about restraining our ability to produce their supply constraint. And that’s what makes this world now very different from what the last 40 years have been. And I think the labor market is the most direct manifestation, but it’s much broader in nature.

Oscar: So all that being said, John, what does this mean for the Fed and their plan around interest rates?

Jean: The big story here is that these forces we talked about here, labor supply being constrained, and more broadly, these production constraints, it’s not something that will be affected or eased by the central bank hiking campaign.

So we just saw the latest decision of the Fed, they’re clearly determined to bring rates up very quickly. Another 75 basis points hike we’ve seen. And as a result this is creating a very important risk for the markets at this juncture. We will see as a result very significant cost for the economy to those hiking campaign without seeing the benefit on inflation for a very long time.

So before they feel they have succeeded in bring inflation down, we will have to go through the cost because that’s actually the only way to bring inflation down through rate hikes is to raise employment and to reduce activity very significantly.

We don’t think this is fully acknowledged by the Fed or any central banks for that matter at this juncture, and so this much sharper cost we’re gonna have to face the reinflation down leads us to be pretty concerned about risk markets.

Now, in fact, we’re underweight equities as a result and that continues to be a conviction. So we think we’re in a world where central banks will be over tightening before they realize that a lot of the issues we’re facing now are things that are not responsive to the interest rate hike.

And if we insist on bringing inflation down, the damage for the labor market and more broadly will be deeper.

Oscar: Well, it’s clear. The Fed has been very busy this year, uh, with interest rate decisions. I think we’re all waiting very patiently to see what the impact of that is in the future. Jean, thanks for all your insights today. And thank you for joining us on The Bid.

This post originally appeared on the iShares Market Insights.

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.