Economic Update: Demographics, Inflation and Productivity

July 5, 2021
Economic Update: Demographics, Inflation and Productivity

Both the global and U.S. economies continue to recover from the COVID-19 shutdown of 2020. While the recovery of various economies differs in intensity, most of the world is seeing positive economic growth.  One downside to this growth has been a global uptick in inflationary pressure, which has largely been absent from much of the world picture for quite some time. I have written on this issue extensively over the last couple of months. 

The question on many minds centers on the sustainability of the recent upward move in overall inflation pressure.  Will inflation be like a passing night train, and leave quickly, or will it prove to be more “sticky” and linger?  Beyond recent commodity price increases lies the longer-term issue of rising wage rates which, if above overall productivity growth rates, will drive inflation to remain on the scene longer than many currently believe, as “cost-push” inflationary trends start to surface. 

Building Blocks We Monitor

Economic growth rates are driven, at the macroeconomic level, by the number of workers with jobs and the productivity of those workers. The more of each, the higher the economic growth rate. If wage growth rates outstrip overall productivity gains, then inflation pressure will surely be not too far behind.  Note the variable that is present in both economic growth and inflation factors is worker productivity.  The number of workers is driven by many factors, but demographics enter the scene.   

Let’s talk about the size of the labor force. I have long believed, as most economists do, that demographic trends are one of the more reliable indicators of future economic pressures and opportunities. Think of it. We know how many 10-year old’s there are in the U.S. That means we currently know (within reasonably boundaries) how many 20-year-olds there will be in our country in 10 years, as these folks enter the labor force. We also know how many people are 55-years old, so we have a good idea of how many official “retirees” are leaving the workforce in 10 years. Consequently, we have the capability of “knowing” some of the pressures our economy may face in the future. That is an example of why understand demographic trends is so important for us to understand. Demographics are economic reality.   

Our friend, Ed Yardeni and I go back to the late 1970s when he was a young graduate with a newly minted Ph. D in economics from Yale – and worked for the old Wall Street firm E. F. Hutton. I was working for a small bank in Kansas at the time and started following Ed’s words. Remember – when E. F. Hutton speaks, people listen. Ed now owns and runs his own economic/capital market advisory firm.    According to Ed’s recent piece: 

The oldest baby boomers turned 65-years old during 2011. Since January of that year through January 2020, the population of seniors has increased 14.4 million.Quite a few of them stayed in the labor force. The number of seniors in the labor force (ILFs) rose 4 million since January 2011 through January 2020, while the number not in the labor force (NILFs) rose 10.4 million over that same period.

The trends may be changing as a result of the pandemic and because the oldest baby boomers are turning 75-years old this year. From January 2020 through May of this year, the population of seniors and the number of NILFs increased 2.2 million and 2.8 million, respectively, while the number of senior ILFs fell 602,000. The labor force participation rate of seniors was down to 18.7% during May from a recent peak of 20.8% during February 2020.

Regarding younger workers, Ed highlights the following: 

The populations aged 0-15 years old and 16-24 years old have been essentially flat for the past two decades. The labor force hasn’t been replenished by a crop of more young people. Instead, it’s been boosted by senior baby boomers working longer. But now they are dropping out of the labor force either because they are retiring or because they’re passing away.

Even before the pandemic, the median age of the population was increasing. It bottomed at 28.4 during 1970. Since then, it increased to 38.3 during 2020. This too reflects the fact that we have fewer babies and more old people who are living longer.

Ed explains that this all adds up to a decline in the growth rate of the work force in the U.S.  Following the pandemic, people seem to be retiring more rapidly than has been the case for quite some time.  Additionally, there doesn’t seem to be enough new youth entering the workforce to take the place of the accelerating retirement of baby-boomers.

Taken at face value, many would consider the demographic pressure of lower growth rate of workers leads to: 

  1. Slower overall economic growth as economic growth is primarily driven by the number of workers adjusted by the productivity of each of those workers. 
  2. Higher pressure on wage growth. Fewer workers make those who are in the workforce more valuable to employers than would have otherwise been the case.
  3. The longer-term impact on inflation pressure could be moderated by growth in individual worker productivity growth. 

So, one major driver of growth and inflation pressure going forward is going to be worker productity growth rates. If, for example, a worker becomes 1% more productive, but wages rise by 4%, then the employer has no choice but to either accept a negative impact on profits or raise product prices. Either growth slows or prices rise, or in the worst of worlds, growth slows and inflation rises. 

This is an example of how important productivity growth rates may prove to be on overall economic growth and inflation. 

Current Productivity Growth Status

Historically, there has been an inverse relationship between unemployment rates and labor productivity growth rates. When unemployment is low, productivity growth has tended to be high. There is also a historical negative correlation between unemployment and inflation-adjusted hourly compensation.  When unemployment is low, wage growth has tended to be high, which makes sense, because when workers are more productive, employers can afford to pay them more.

During the first quarter of this year, worker productivity rose by 5.1% from the first quarter of 2020 (chart above). Historically labor productivity increased by between 1% and 2% over most periods. If anything like a 5% gain in productivity is sustainable, then the inflation scare may be just that – a scare without real teeth. 

But we need to remember, productivity growth tends to accelerate significantly as the economy comes out of recessions. We will closely monitor this very important data point going forward. 

Going Global

The folks at the highly respected economic firm Capital Economics believe that global (and yes, U.S.) inflation rates will rise on a more sustained basis than has been the case for a number of years.  Their core global case calls for inflation to average 3.5% annually over the next few years. They also believe interest rates for government bonds will have an upward bias. 

In the “developed” world, they are looking for inflation to be more intense and of higher concern in both the U.S. and Australia than in Europe or Japan.  In the “emerging” world’s economies, they suggest that inflation trends will be noticeable and problematic in central Europe (Russia, as an example) than in most parts of Asia. 

Capital Econ expects core inflation to remain above 2.5% over the next two years and labor costs to rise more than 3.5% per year in the U.S. over the next two years. They think the inflationary seeds are global in their reach. This view naturally leads to central bank activity. As central banks globally have remained in a very accommodate stance, if inflation proves to be more than just “transitional” in nature, what policy action may be in the cards? 

Change in market rate expectations and latest annual cpi inflation rate

Certainly, the global bond market two-year government bond yields have been rising, in anticipation of inflation trends being stronger than some expect. The Refinitiv, Capital Economics chart shows country- specific changes in two-year government bonds (blue bars) as compared to the latest CPI data from those countries (black dot). Note that two-year bond yields have been rising across the globe, but at a lesser rate than 12-month inflation. This suggests that, while inflation has certainly heated upward, the markets are not yet sold as to the sustainability of those trends. 

Last Word

So where does all of this leave us in our view towards building inflationary pressures? I have covered this view before this piece, and I reiterate my thought that it is still too early to make a call that inflation is going to be 3%+ over the next two years. Much of what we have experienced can be attributed to shorter-term factors (commodity prices, “base” year calculation issues) rather than a more sustainable, cost-push driver for longer-term inflationary pressures. We will be able to provide more solid guidance on that issue as we see developments in the labor market here in the U.S. as the summer grinds on and we reenter the fall. Why is that time frame important? I suspect we will see further healing in the labor market as school starts up and parents are able to come back into the workforce, providing a nice upward push in labor supply. 

I am calling for inflation (all items) to register a year-over-year gain of 3.5% late this year, and 2.5% – 3.0% next year. So, I currently stand in the “moderation camp” and am looking for inflation to average around 3% over the next two years. 

Sound scary? It shouldn’t be. According to the folks at the St. Louis Federal Reserve, all items inflation-related have averaged 3.7% per year over the last 50 years. So, while higher than we have seen for some time, a 3% inflation rate shouldn’t upset business trends over the longer term.   

The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.

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