Help Wanted: Why Inflation Fears Might Actually be Right this Time

Drawdowns in the labor pool may be faster than many people realize and have important financial market implications

October 05, 2018

For a long time after the financial crisis, a large pool of unemployed and underemployed workers – and corresponding weak wage growth – kept U.S. inflation in check. However, as the unemployment rate has declined to historically low levels, consumer prices have been slow to rise, puzzling many economists. Some market commentators have highlighted the role of the decline in labor force participation as a factor. They argue that even though unemployment is near all-time lows, a large number of people who are not part of the labor force might consider entering, and their presence is enough to keep inflation low for the foreseeable future.

QMA’s analysis of recent U.S. labor statistics shows that the pool of available workers is being drawn down much more quickly than many people realize – with important implications for financial markets. In its latest Market Pulse  PDF opens in a new window, QMA shows that as the current rate of new job growth eats away at the number of workers actually available to work, the U.S. labor force could hit levels of tightness next year last seen in the late-1960s, just before the 1970s inflationary spiral.

 

Hire and Higher

According to the July jobs report, the economy added 224,000 jobs on average per month over the last three months, an annualized rate of 2.7 million.That’s up from a rate of 2.2 million added in 2017, before the December 2017 Republican tax cuts, and starting to be more in line with the yearly job gains seen earlier in the cycle.

Job Gains Heading Back Up Again? (Seasonally Adjusted)

 

Month

Changes in Employment Levels (thousands)

Jan 2004

180

Aug 2004

1786

Mar 2005

2017

Oct 2005

2214

May 2006

2548

Dec 2006

2095

Jul 2007

1512

Feb 2008

756

Sep 2008

-1340

Apr 2009

-6209

Nov 2009

-5491

Jun 2010

-500

Jan 2011

1079

Aug 2011

1708

Mar 2012

2455

Oct 2012

2124

May 2013

2164

Dec 2013

2301

Jul 2014

2667

Feb 2015

3127

Sep 2015

2676

Apr 2016

2643

Nov 2016

2398

Jun 2017

2357

Jan 2018

2105

Jul 2018

2400

Source: Haver Analytics, QMA as of 7/31/2018.

QMA estimates that the number of unemployed will shrink by about 1.4 million in the next year. That could bring the unemployment rate down to about 3.3% by the summer of 2019 and potentially below 3% by the end of 2019, even allowing for a like number of net new people coming off the sidelines (about 200,000 a year) who have been rejoining the labor force over the past five years.

 

The Connection to Stocks

Recall that the correction in stock prices in February 2018 was triggered by high valuations in combination with a hot wage number. Subsequent reports have been less worrisome, and markets are again around all-time highs. If QMA’s analysis is correct, higher wage numbers might become pretty common sometime over the next 18 months or so.

While rising wages would be a welcome relief for Main Street, it could cause problems for Wall Street and for the Fed. Wall Street would see the historically high profit margins that have recently provided support to valuations begin to compress, unless companies are able to pass on the cost increases to consumers. The Fed might have to choose between letting wages and inflation run a bit hot, risking rising inflation expectations, or tightening monetary policy more rapidly than planned, potentially causing a recession.

QMA does not view the situation as imminent, remains overweight stocks in their multi-asset portfolios, and is reasonably optimistic that rising productivity could support higher wages without inflation getting out of control. However, they are watching the dynamics of the labor market very closely for signs that the tipping point for wages might be closer than the consensus thinks.

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