Covid-related labor imbalances complicate Fed's inflation fight

Putnam Fixed Income Team, 08/17/22

“So there’s a feeling that the labor market is moving back into balance. If you look at — if you look at job openings or quits, you see them moving sideways or perhaps a little bit down. But it’s only the beginning of an adjustment.”

– Jerome Powell, Chair of the Federal Reserve, July 27, 2022

Today’s high inflation environment results from many contributors — China’s zero-Covid public health policy, the U.S.’s excessively accommodative fiscal and monetary policy, and the Russian invasion of Ukraine, to name a few. In our view, pandemic-induced changes in work and life arrangements have also contributed to, or catalyzed, the start of this high inflation period. Changing U.S. demographics have a possible long-run impact on the labor market and interest rates. While inflation is a policy choice, and the Fed has clearly shown its preferences, the central bank might also be misdiagnosing labor market conditions due to changes related to the pandemic.

Age and disability effects on inflation

The U.S. population has continued growing — albeit at a slowing pace — since the pandemic started, but the composition of the working-age population has changed notably. The number of people with disabilities has been rising relative to people without a disability. This shift might have disturbed consumption-saving decisions that determine long-run interest rates while tightening the labor market overnight.

People with disabilities are rising as a share of the working population

U.S. working age population (16 or older)

people with disabilities rising share of working-age population

Source: Bureau of Labor Statistics.

When many people become disabled at the same time, it causes a sudden increase in net consumers relative to net savers. As the number of savers declines, the equilibrium real interest rate, or the required rate of real return on investments, goes up. As the number of consumers increases, prices also rise until a new equilibrium is achieved. The result would be a transitory period of inflation, or inflationary pressures, independent of the stance of monetary or fiscal policy.

Also, the overall labor participation rate has not returned to pre-Covid levels because of the low participation rate of people over 65. Looking even more closely at the over-65 group, we can see that it is people without a disability whose participation dropped at the start of the pandemic and has not made any meaningful recovery. In contrast, the participation rate for this older age group had surged from 2017 to 2019. This period happens to be Powell’s favorite, in our view.

People over 65 without disabilities remain reluctant to return to work since 2020

Composition of U.S. labor force participation rate people over 65

Over-65 people without disabilities remain reluctant to return to work since 2020

Sources: Putnam calculations, Bureau of Labor Statistics data.

It’s possible that over-65s (who are eligible for retirement benefits) have shown less willingness to work due to the positive wealth effects via QE-driven asset and home-price appreciation, and that this could reverse somewhat as the financial markets remain in turmoil. However, a large share of these people will not be able or willing to work due to old age. Bringing those people back to the labor market might require significantly higher wages and/or significantly lower asset prices. This adds to the story that the U.S. labor market might be structurally very tight.

Youth and the future

For a complete view on economic growth and the balance between savers and consumers, we need to take the other major dissaving group — children — into account. The pandemic affected fertility rates, too, and the under-16 population has declined. This would typically mean less pressure on equilibrium interest rates and growth, but it is being cushioned, if not offset, by the rise in the number of people with a disability. The downward pressure on long-term interest rates would be stronger, if it were not for the sudden rise in social security old age and disability beneficiaries.

Population changes tighten the labor market

The sudden change in U.S. demographics along with very accommodative policy seems to have tightened the labor market. Fewer children today mean fewer workers in the future, and pressure in the labor market can persist. On the other hand, life expectancy after retirement seems to be declining. If the pandemic has enhanced this trend, it would mean reduced pressure in the labor market over time. In the near term, however, it can be inflationary for prices and wages if retirees accelerate consumption due to shorter retirement time frames.

A smaller youth cohort appears to be a global phenomenon since the pandemic started. It’s hard to say yet whether this is a behavioral shift, or a trend that will reverse as people adjust to living with the virus. If it is a long-term behavior, it is bad news for global growth. It’s worth adding that, while more immigration could solve the low U.S. growth problem, it would not change the trend of declining global population growth, which is what asset markets are linked to, directly or indirectly.

Another factor that can increase labor supply is immigration. This could relieve pressure, but first-generation immigrants tend to have more children than other generations, and so the impact on long-term interest rates is ambiguous. Also, in the very short run, immigrant flows tend to be inflationary.

Central banks unable to correct short-term imbalances

The Covid-19 pandemic has caused changes to U.S. demographics that has shocked near-term demand-supply balances in an adverse way, but without changing the long-term trajectory of interest rates. The policy misdiagnosis, along with supply chains that were built on the premises of maximum efficiency, have augmented this near-term shock. Central banks are now trying to bring demand and, hence, inflation down. However, with this very tight labor market backdrop, bringing inflation back to 2% will likely be a challenging task. The notion that a drop in job openings will suffice to kill off inflation seems like wishful thinking.