Assessing Inflation

Now that the unemployment rate has dropped to below the “natural rate of unemployment”, which is the rate associated with a healthy economy, the course of monetary policy will be determined largely by the Fed’s second mandate – maintaining price stability. Until recently, most inflation data has come in surprisingly weak and well below the Fed’s target of 2%. The Fed has attributed the low growth rate in prices to transitory factors such as a drop in wireless telephone services and prescription drugs. Once the effects of these factors subside, they say, inflation will climb back toward their goal of 2%. Are they right? One recent data point suggests they might be. Last Friday we received word that Average Hourly Earnings rose 2.9% year-over-year in September – well above expectations and the best rate of growth since mid-2009. Should the Fed be fearful that the day of reckoning is here?

Periods of rising inflation generally begin when the excess capacity created by a recession gets wrung out of the economy. When speaking of excess capacity, economists are generally referring to available labor (the pool of unemployed workers) or idle factory capacity. For purposes of this Market Commentary we will focus on the pool of available workers. As an economy starts to recover from a recession, companies hire unemployed workers in an effort to meet improving demand for their goods or services. During this process of absorbing previously unemployed workers, wage inflation can be fairly modest in the beginning stages. However, there comes a point whereby it becomes more difficult for companies to find prospective workers with the skills needed to fill their open positions. This is the point at which wage inflation begins to materialize in earnest. Companies must pay more in order to attract qualified workers. And higher wages tend to trigger more widespread inflationary pressures throughout the economy.

Since the peak during the Great Recession, the ranks of the “unemployed” have shrunk from 15.4 million in October, 2009 to just 6.8 million in September, 2017. I used quotation marks for the word unemployed because the folks counted as unemployed by the Bureau of Labor Statistics must be considered to be “in the labor force” by having actively sought a job in the previous four weeks. Therefore, any unemployed workers who have not actively looked for work in the past four weeks are deemed “not in the labor force.” Why is this important? Because there has been a staggering 13.5 million increase in the number of people “not in the labor force” during the 8+ years since the Great Recession ended in June, 2009. Why, during an economic recovery, have people been leaving the labor force in droves? Normally, the increasing opportunities created by an economic recovery would be expected to draw people back in the labor force.

Source: Bureau of Labor Statistics, US Census Bureau

The chart below (which is the inverse of the “Labor Participation Rate”) shows the trend in people leaving the labor force, even throughout the economic recovery, until very recently. Because the ranks of the “unemployed” have shrunk to just 6.8 million (representing just 4.2% of the civilian labor force – a level considered “full employment”), the only way to determine whether wage inflation will soon become a big issue is to determine how many folks will abandon their current status of “not in the labor force” and rejoin the civilian labor force. If several millions are expected to rejoin the labor force and compete for jobs, we probably shouldn’t expected a huge spike in wages. However, if very few are expected to rejoin, then companies are going to have to fight over a shrinking pool of available labor by raising wages.


Source: Bureau of Labor Statistics

One of the factors that has clearly been contributing to the rapid growth in those “not in the labor force” has been retiring baby boomers.  The oldest of the baby boomers hit age 65 in the year 2011, and, based on birth data for the baby-boomer cohort, some 25 million baby boomers have hit the retirement age of 65 since then.  It is hard to say with any accuracy how many of these boomers actually retired at 65, how many retired many years ago, or even how many are still alive today.  And then we must consider that the pool of young workers entering the labor force for the first time has offset some of the boomer retirements.  In any case, it is clear that retiring boomers are part of the story told by  the above chart.  But they’re not the whole story!  Where are the rest, and are they coming back?
There are a couple additional considerations that could determine how fast prices rise in the future.  If the Trump administration were to succeed in its goals of limiting immigration (both legal and illegal), we could expect that future labor shortages would positively impact the pace of wage growth.  As well, if Congress were to be successful in passing fiscal initiatives, like large-scale tax cuts or infrastructure spending, these initiatives could spark the inflation necessary to make the Fed nervous.  Save for these fiscal shocks, though, most economists are having troubling forecasting inflation based on the questions regarding the mass exodus from the labor force.  We suspect the Fed may be pondering the same questions.