U.S. Inflation: Working Out the Impact of Labor Costs
VOICEOVER: Welcome to the Investment Conversation. I’m Tony Fisher.
Giulio Martini: So there are a lot of vacancies and businesses have been more successful at filling them than ever.
Despite that, what we're hearing is widespread reports that businesses don't have as many workers as they need and that's because the quit rate is also extremely high, so businesses are getting a lot of people in the door, but there are a lot of other people going out of the door.
Voiceover: The U.S. economy is on the move—and so are the people who power it. As the recovery builds, and employers seek to staff up in response to the rebound, workers appear more willing than usual to consider changing professions and industries, and it seems likely that elevated levels of job turnover are set to continue. What are the implications of these trends for wages, and by extension, U.S. inflation? As a follow-up to our May podcast on inflation, my colleague Will Andrews recently sat down with Lord Abbett Partner & Director of Strategic Asset Allocation Giulio Martini to take the temperature of the U.S. labor market.
Will Andrews: Giulio, you’ve been keeping us up to speed on the inflation story, both in articles on lordabbett.com and in a recent podcast. You reminded our listeners that “inflation is a process, not an event.” Where are we in the process right now?
Giulio Martini: Well you're right, Will … inflation is a process and inflation is something that first of all, is very broad it's defined in terms of a very broad basket of goods and services that consumers buy and it's a situation where the prices of those goods and services accelerate kind of in tandem over an extended period of time.
If we look back at history, there have been two 15-year periods, where the rate of inflation in the United States accelerated steadily to a double-digit peak. One began in the mid-1930s and extended to the late 1940s and the other began in the mid-1960s and extended to the early 1980s, so inflation is a complicated process. There are many chains of cause and effect that go into it and cause it to extend over a long period of time.
The two big drivers of the process are monetary and fiscal policy. If we look back, both of those 15-year periods were periods when the government was increasing its spending dramatically for different reasons. And they were periods when the Central Bank, the Federal Reserve was accommodating those increases in spending with a permissive monetary policy, so those are the two big elements that really drive the inflation process and keep it going over a long period of time.
Andrews: Okay, so we know a bit about the process .. can you just tell us right now, maybe just give us a brief bit on the current inflation situation and kind of where we're standing.
Martini: Well, the current inflation situation is something that's taking place after a 25 year period in which inflation has been low and stable for the entire time. From the mid 1990s really all the way up to 2020 before we entered the pandemic and that was quite striking that we had in place in averaging under 2% with very few episodes where it deviated meaningfully from that average. Now what we're going through is a situation where, after the shutdown period last year, prices fell dramatically.
What we're experiencing is the reopening of the economy, gradually, and a shift in demand from services into goods. And what we're seeing is that these dramatic changes in demand and economic activity are leading to some short term inflationary pressures, for example. You know, cars and refrigerators require semiconductors today to be produced … there's a shortage of semiconductors because the demand for consumer durables has gone up so sharply that there's not enough semiconductor capacity in the world in the short term to accommodate those increases in demand. So we're seeing not only a shortage of new cars, but a spillover of demand on to used cars, which has made us car prices go up you know dramatically by 10 and 20% over a short period of time.
Now that is a price level increase for that set of goods that consumers are demanding and very large and unusually large quantities right now. But it's not necessarily an inflationary process, in other words, when we get through the short run period when semiconductor supply gets ramped up when new car production gets ramped up and use card demand goes down we're going to get an adjustment in prices. That reflects a longer running lower sustainable level of demand and in place and we'll come back down.
That kind of price level shift is not inflation, it's just a transitory situation. To become inflationary, it has to sustain itself beyond the current period. And where the uncertainty is right now is whether [that] after this long period of low and stable prices, something is going to change during this transition. Which leads to higher inflation going forward rather than just a price level adjustment in the interim, as the economy, you know, responds.
Andrews: That actually sets up the next question rather well. We've been also following developments in the US labor market, and you've been commenting on that extensively. Why is this so critical to the inflation story?
Martini: Well, the labor market is critical to inflation, because wage cause then wage costs and benefits payments to labor are ultimately responsible for 60 to 70% of total production costs in the economy..
Then reverberates back into wage increases that reflect the increase in the cost of buying those things and labor being able to translate that into higher wages, then you're not closing the loop.
That creates an inflation in costs that then leads to an inflation process that then leads to inflation and cause that then leads to inflation and prices etc, and since labor is the fundamental cost of production, unless labor costs accelerate consistently you're not going to have a long period of rising inflation.
Right now we're in a situation where the unemployment rate is just above 6% which is kind of the long term average more or less through the US economy. But it's something that you wouldn't expect to see increases in labor costs taking place, but we are seeing those nevertheless. And I think what it really has to do with is some frictions that are associated with a pandemic itself, for example.
It’s estimated that over a million people have retired early as a result of the pandemic who wouldn't above otherwise retired, so that's a decline in labor supply that's permanent. There are also a lot of people who are hanging back from taking jobs because they're worried about health risks that would be associated with going back to work, for instance in something like you know, a restaurant or something.
Like retail, which has a public-facing dimension, people are worried about you know getting the virus from going back to work in those kinds of jobs. People also have more responsibilities at home for taking care of children while school are closed, maybe for taking care of relatives who have had health care problems themselves.
And then lastly there's also the existence of generous unemployment benefits in many cases, which allow people to hang back from picking work, so what we're seeing is notwithstanding that unemployment rate that's just about the long-term average that it looks like labor supply is restricted.
And, as a result, businesses are having trouble hiring people; they're also having trouble hanging on to people. And so we're seeing them increase their wage offers at a point in the business cycle, where you wouldn't necessarily expect that, and that, if it sustains itself, you know, provides a hint that maybe inflation is moving up a little bit.
Andrews: Giulio, this seems like a good time to take a bit of a deeper dive into labor market data. You know we always hear about the nonfarm payrolls in the monthly report, unemployment rate,
average hourly earnings. But there are many dimensions to the labor market picture, maybe you could give us some color on some of those some of the ones that you follow.
Martini: Well, I think the dimension that's most interesting right now is the data on vacancies and data on quits, and also data on job separations which is detailed data that comes out about a month later than the employment report that we all follow. Vacancies are at an all-time high in the United States, right now, in other words, businesses are trying to recruit more workers than they've ever recruited before. And also, when we look at gross hiring, [it] is extremely high--higher than it's ever been before So there are a lot of vacancies and businesses have been more successful at filling them in ever.
Despite that, what we're hearing is widespread reports that businesses don't have as many workers as they need and that's because the quit rate is also extremely high so businesses are getting a lot of people in the door, but there are a lot of other people who are going out of the door, okay, and that's a combination of the fact that, you know ,people are really in many ways reassessing their lives as a result of the pandemic and asking themselves “is the job I have really the job that I want? Is it really, what I want to spend my life doing”? And in many cases, people are changing jobs, you know, to get a better fit and also businesses are offering higher wages, so the reward for changing jobs is quite high, and also because vacancies are so great that people are not worried if their decision doesn't work out they think they can find another job very easily.
So what we're seeing is an elevated quit rate together with a very high vacancy rate. And then the last piece of that is that the layoff and discharge rate, in other words, people being involuntarily terminated from their jobs, is also at an all-time low. So you know businesses are trying desperately to hold on to the workers, they have to add as many workers as they can is reopening takes place and they're being frustrated by the fact that quits are very high, so we're seeing this tremendously dynamic tension in the labor market that is completely atypical and it's sort of hinting at the fact that in this transition period, you know that the new normal is not what the old normal was, and it may be, you know, there's a little bit of power shifting to workers in the labor market that that companies used to have previously.
And again, it may not be that surprising that that's taking place, you know we're living through this giant, unprecedented historical event. And it would be surprising in a way, if we came out on the other side of it just on the path we were on before without things changing structurally. And maybe you know, this apparent mismatch between workers and jobs, between people in their aspirations, between willingness to work pre- and post-COVID is a manifestation of some of the important changes that this pandemic itself is triggering.
Andrews: Giulio, I wanted to follow up … you said something intriguing before about the potential effect of expiration of unemployment insurance, and I think that could be a potential wild card going forward. Can you expand on that a bit?
Martini: Well, you know, the decision was made during in the early stages of the pandemic when the economy was in the shutdown period beginning in March of 2020 that policy would respond very aggressively to support the income of workers who had been laid off from their jobs as a result of the health care crisis. And, you know, this was a very good decision in my mind, because it prevented the healthcare crisis from spiraling into an economic and financial crisis that would have made everything even worse.
So demand was supported and demand was supported very generously, in the sense that the Federal Government supplemented the state benefits that people normally receive with an extra [indistinct] and you know state benefits normally cover about 40 to 45% of the income that someone had before they were laid off and they're only available to less than 50% of all workers because there's some pretty stringent criteria in most states for receiving unemployment benefits. So the federal government stepped in and said look in this case we're going to loosen the criteria we're going to make almost everyone who lost their job or who can't work eligible, including self employed people, including independent contractors, and we're going to supplement that state benefit first with a $600 per week federal benefit, and now, with a $300 a week federal supplement. So that's been cut back, but for many people, the combination of what they were receiving from their state unemployment insurance funds and the federal supplement was actually more than their income before when they will work, and that was a decision that was made to sustain demand in the economy, as quickly as possible.
Now, a lot of people have speculated that those generous unemployment benefits are preventing people from going back to work and there's a very active debate about whether that's true. In my mind, the statistics don't support that at this point in time, and, as I said before, you know, businesses are hiring people at record rates, you know, so apparently they can find a lot of people. The problem is, they can prevent their existing workforce from quitting in large numbers. Now people who quit their jobs are not eligible for unemployment benefits … you only receive unemployment benefits if you're involuntarily terminated from your job or [if] you’re the subject of layoffs and we know that those rates are at all-time lows. So in my mind the bigger issue with difficulty in hiring is that firms cannot prevent a lot of people from quitting for better alternatives elsewhere or for other reasons that they may have for wanting to stop working in their current job. So the data, in my mind, doesn't support the interpretation that it's really generous UI that's keeping people from accepting jobs at this moment.
Andrews: Giulio there's a lot to digest here, given all you've told us right now, what is the key takeaway for investors, what would you tell them now?
Martini: The key takeaway is that if we are in the process of an acceleration of inflation, we are in the very early stages of that process, and it is by no means certain that we're embarking on a multi year period in which inflation will rise, and what that means is that it is far too early to derisk your portfolios and go into a defensive posture. Inflation is very bad for investors … if we look at the periods in American history when inflation is accelerated, you know, over a long period of time, they've been periods of very bad returns for holders of risk assets and so, if we were accelerating into such a period, you would want to be defensive, but it is by no means clear that we are.
If we are we're in the early stages of that process and the early stages of that process tend to be quite benign and so it's too early to become defensive. That's the most important message that we can give to investors.
Andrews: Giulio, thanks for speaking with us today -- we'll be sure to follow up in a future podcast.
Martini: My pleasure, Will, and I look forward to doing it again soon.
Andrews: If you’d like a transcript of today’s podcast or have any further questions on inflation-related investments, please contact your Lord Abbett representative. And as always, you can read more Economic Insights from Giulio Martini on lordabbett.com.
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