High inflation, but not stagnation

My first childhood memory is of sitting in the back of a station wagon with my brother. My mother was at the wheel, and we were in a long line waiting for gasoline. It might have been 1974; I learned, at some point, that an embargo by oil-producing nations had created shortages that led to even-and-odd-day rationing. The last number on our license plate was 8, so we could buy gasoline only on an even-numbered date.

I’ve thought about this recently because shortages of various goods and services, coupled with inflation like we’ve not seen in ages, have some observers wondering: Are we about to revisit the 1970s? I understand the concerns. Rapidly rising inflation eviscerated the economy then. The unemployment rate rose dramatically. It was a terrible environment for investors for two or three years.

I can tell you that, no, we’re not about to enter a period of stagflation—stagnant economic activity amid high unemployment and inflation—like the 1970s. We continue to anticipate economic growth and, unlike in the 1970s, demand for workers is high. Among several challenges, the most significant factor holding back the economy now is a lack of workers.

Figure 1. Supply, labor shortages act as a drag on growth

The chart depicts quarterly GDP lost to labor and supply constraints since 2007, just before the global financial crisis. Supply constraints have been significant lately, and especially right at the outset of the COVID-19 pandemic in the first half of 2020. Now, though, the shortage of workers is starting to influence Vanguard’s forecasts more significantly.
Source: Vanguard calculations, using data through September 30, 2021, from the U.S. Bureau of Economic Analysis and the U.S. Bureau of Labor Statistics.

The brown bars in Figure 1 represent economic output lost because of a shortage in the supply of goods—kitchen cabinets or whatever you want to buy—losses that have intensified since the pandemic started early in 2020. If you’re looking to buy a new or used car or trying to complete a home repair, you’ve likely experienced supply shortages firsthand. If you’ve been successful in your efforts, you may have paid more than you expected. Such supply tightness shouldn’t come as a surprise; for many workers, although their lives were disrupted by the COVID-19 pandemic, their paychecks weren’t. Online demand grew incredibly strong at the same time production was disrupted globally.

Now, though, the shortage of workers, represented by the bluish-green bars in Figure 1, is starting to influence our forecasts more significantly. Although we still anticipate significant growth, we’ve lately downgraded growth forecasts for many countries and regions, and it’s not because demand is weak.

Figure 2. A crackdown on debt in China adds to growth pressures

The chart breaks down the share of household wealth in China and the United States. Housing account for almost twice as much of household wealth in China as it does in the United States. In China, 59.1% of household wealth is in housing, 20.4% in financial assets, and 20.5% in other physical assets. In the United States, 30% of household wealth is in housing, 43% in financial assets, and 27% in other physical assets.
Source: Vanguard calculations, using data from the People’s Bank of China and the U.S. Federal Reserve through 2019.

At the same time, China is working to mitigate leverage in the financial system, specifically in the property market. China is intentionally and permanently changing its business model, and I think the market underestimates this. China is no longer focused solely on driving real estate expansion and leverage to become a middle-income economy. When it fixates on a problem, it doesn’t let go, and now China is repivoting its growth model again. My colleague Qian Wang wrote recently about the growth paths that China is navigating.

Real estate has accounted for roughly 30% of China’s growth. In the United States, it accounted for, at most, from 10% to 15% before the global financial crisis. So there’s a concerted slowdown in China, although nothing alarming in the sense that we’d see a hard landing. But it’s coming at the same time that we’re seeing constraints on U.S. and European economies that want to run faster but can’t because of a lack of availability of goods and services.

Figure 3. Job openings per unemployed worker are at an all-time high

The chart depicts the ratio of job openings to unemployed workers since 2000. Ratios over 1.0 signify labor shortages, while ratios below 1.0 signify job shortages. Job shortages were prevalent for most of the period and were at their greatest at the start of the global financial crisis. Labor shortages have become the rule in the last several years, interrupted briefly by the onset of the COVID-19 pandemic but now back to an all-time high.
Source: U.S. Bureau of Labor Statistics, accessed August 30, 2021, through the Federal Reserve Bank of St. Louis FRED database.

So how does this play out? We have growth slowing in the United States and China. We have oil prices shooting higher again. Is it going to be like 1974? The answer is clearly no. The one big difference—and it’s a material difference—between the environment in 1974 and the environment today is that demand for workers now is extremely high, as Figure 3 shows.

The reason we have supply and labor shortages is because incomes have been growing, policy support from the federal government has been as large as it was in World War II, and now we have the economy coming back online. We’ve underestimated supply chain disruptions but demand wants to go further still. It’s why we’ll see higher inflation, but not a stagflationary environment.

Figure 4. Labor market red-hot in “non-COVID” sectors

The chart depicts ratios of job openings to the unemployed in July 2021 in three sectors: information technology (1.33 to 1 ratio), financial services (1.86 to 1), and professional services (2.01 to 1). All ratios are higher than in previous high points in December 2000.
Source: U.S. Bureau of Labor Statistics, accessed August 30, 2021, through the Federal Reserve Bank of St. Louis FRED database.

Figure 4 breaks down the number of openings per unemployed worker in three sectors—information technology; financial services; and professional services, such as law firms—that were not engaged in the face-to-face activities so disrupted by the pandemic. The ratio of job openings to unemployed or marginally employed workers in professional services? Two to one. I added the lighter-shaded bars to show the last time the labor market was ever this tight, and we’ve surpassed that.

There is a genuine significant pressure on demand and we will continue to see it. Among the reasons these conditions have become so acute so quickly is that a number of workers have stopped looking for work. Part of this pressure will be relieved. Wages are starting to go up, which will draw workers back, and this is very positive news given some of the profound shocks that had hit the global economy. But this introduces different risks to the forecast. The risk in the next six months is growth that’s perhaps a little bit weaker than expected in the United States and some weakness in China with its real estate clampdown.

But the darker-shaded bars in Figure 4 aren’t coming down very quickly, which means we have a shift in risk in the next 12 months. If in the near term there’s a modest downside risk to the markets, if they’re vulnerable to a downside risk to growth, the further-out risk is when the supply chain disruptions start to moderate. When all those cargo containers off the port of Los Angeles can finally be offloaded, we’ll have another issue: The Federal Reserve will need to normalize policy.

Figure 5. Monetary policy remains historically accommodative

The chart depicts a proprietary Vanguard measure of whether U.S. monetary policy is loose or tight. It shows policy typically as loose during and after recessions but eventually becoming tight during recovery from recessions. Monetary policy has remained loose, however, for more than the last decade and is as loose as it’s been over the last three decades.
Notes: Vanguard’s proprietary monetary policy measurement examines the effect of the policy rate, central bank asset purchases, and inflation relative to the neutral rate of interest to gauge how “tight” or “loose” policy is.

Sources: Vanguard calculations, based on data from the Federal Reserve, the U.S. Bureau of Economic Analysis, Laubach and Williams (2003), and Wu-Xia (2016). Accessed via Moody’s Data Buffet as of September 30, 2021.

Figure 5 reflects Vanguard’s assessment of whether monetary policy is stimulative or tight. The higher the line, the tighter the conditions, which you tend to see if inflation is out of control and the labor market is already at full employment. The shaded areas represent recessions. The COVID-19 recession was deep, but it was so short that it barely registers on the chart. You can see how stimulative that monetary policy was—appropriately so—during the recovery from the global financial crisis. But monetary policy is more stimulative today than it was during the global financial crisis, and this isn’t a debt-deleveraging recovery. This chart doesn’t reflect fiscal policy, but if it did, we’d need another floor.

Policymakers have been extremely successful in arresting a horrible shock. It’s a reason many companies didn’t go under. In one sense it was a heroic effort. But the critic in me says: Be careful of fighting the last war. If we wait too long to normalize, we’re going to have another issue on our hands, the potential for strong wage growth to fuel more persistent inflation. If we get past the supply chain issues, which I think we will, the Fed will have to be adept. It should not raise interest rates now in the face of a profound supply shock. But when those conditions are ameliorated, the Fed will need to have the conviction to raise rates in an environment where the inflation rate may be coming down and the labor market continues to tighten.

The time of 0% interest rates should soon come to an end. That will help keep the growing risks of more permanent inflation at bay.

I’d like to thank Vanguard Americas chief economist Roger Aliaga-Díaz, Ph.D., and the Vanguard global economics team for their invaluable contributions to this commentary.

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