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.

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.

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.

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 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.