Where Have All The Workers Gone?

PRODUCTIVITY & GROWTH

Economic growth is affected by millions of factors, but in the end they can be summed up with just two numbers. The number of people working and how much the average worker produces. In the final months of last year businesses faced with worker shortages and supply chain disruptions were unable to meet soaring consumer demand. The incentive to get each worker to produce more was huge. At least in this respect this cycle proved typical. Productivity always soars in the early months of a recovery. This cycle is however unique in several respects. Unlike most recoveries when business slowly adds workers, people returned to work at a frantic pace when Covid restrictions were eased in the new year. Increased productivity and a rapidly expanding work force enabled the US economy to grow 1.6% (6.4% annualized) in the first quarter of 2021. Since then the pace of hiring has slowed. Productivity gains will also slow as businesses bring back their least productive workers. Over the past decade the productivity has only risen about 1% per year while growth in the work force has increased by a similar amount. Productivity should improve in the next few years. Companies faced with both strong demand as well as soaring labor and material costs will increase investment. Low interest rates and big cash positions make those decisions easy. Business investment in plant and equipment that deploys new technology is the the best indicator of future worker productivity. Surveys indicate that companies are planning a 15-25% increase in the pace of new investment in new technology during the the next 5 years. Those investments boost output while mitigating the rise in consumer prices. A portion of that increased productivity flows to the worker in the form of higher wages. That said, improved technology offsets other cost increases as one employee is able to produce what two or more employees formerly produced. Unfortunately, the productivity of the displaced workers falls. Years of experience and training suddenly become a lot less valuable. Historically net productivity gains tend to be roughly proportional to the percentage increase in investment. Excluding the huge swing since the shutdown productivity was growing about 1% per year for the previous decade. If companies stick to the announced investment plans worker productivity is likely to rise 1.15% to 1.25%. Even annual productivity gains of 1.5% fall far short of the reduction in work force growth from 1% annually to zero as 10,000 baby boomers turn 65 every month. As is typical when economies recover, both hiring and productivity have risen faster this year. Although real growth has slowed since the first quarter it is still likely to approach 4% in 2021 as the global recovery increases US exports. The lack of workforce expansion will return growth to it's sub 2% trend next year.

INFLATION & GROWTH

A few years back I suggested that the Feds effort to boost inflation would succeed beyond their wildest dreams. In normal cycles there is a long lag of 12-36 months between the time the Fed expands money growth and consumer prices rise more than they otherwise would. The lags are relatively shorter when the monetary expansion is financing government deficits than when it is fueled by loan growth at banks. The immediate economic boost from big deficits in early 2018 fueled rising inflation late in 2019. It takes ever larger deficits to overcome the drag on growth exerted by rising prices. Last years shutdown slowed the price hikes, but prices still rose. This year inflation is once again accelerating faster than the growth in output as it has for the last few years. You may have seen the headline that economic growth rose to 6.4% in the first quarter. You probably haven't heard that consumer prices rose 7.4% in the same time period. The press reported that consumer prices were up 2.6% at the end of March. That 2.6% number represented price changes over an entire year, whereas the 6.4% number was arrived at by multiplying the 1.6% quarterly gain times four. When you calculate CPI the same way prices rose 7.4%. Since then growth is slower even as consumer prices are rising faster.

INFLATION ( continued) Between March and May "transitory" shortages of almost everything pushed consumer prices up at a 9% annual rate. This a mirror image of the "transitory" price reductions during the shutdown in Spring 2020. The shortages will diminish as export oriented economies reopen, companies slowly ramp up production, and price hikes slow spending. The pace of price hikes will slow, but inflation will remain elevated. The 3.1% rate of price increases since the end of 2019 provides clear evidence of the accelerating price trend net of both "transitory" distortions. That rate is about 65% percent faster than the sub 2% inflation of the prior decade. The seeds of that inflationary trend were planted in 2017 with tariffs, reduced immigration and massive structural deficits financed by the FED monetary expansion. Last year's 25% expansion of M2 is only starting to impact the numbers. Consumer spending remains strong, but not as strong as the lines at stores and restaurants would lead you to believe. It just takes a lot longer to spend the money when stores and restaurants have occupancy restrictions and much of what you want is eithersold out or priced high enough to make you think twice. The recent deceleration in retail sales growth hasn't alleviated the shortage of employees necessary to manufacture, deliver, stock, serve and/ or sell the stuff. Full employment is putting huge upward pressure on labor costs. Numerous public companies have announced that rising labor costs are forcing them to raise prices. Those price hikes reduce purchasing power emboldening workers to seek further pay hikes in an inflationary cycle. It is no wonder that inflation expectations are rising. Residential rents are probably an even more important driver of both actual inflation and consumer expectations. Housing absorbs the lions share of consumer income. Appropriately rent represents almost a third of the consumer price index and is closer to 40% of core CPI. Rents have been suppressed for over a year by eviction moratoriums. Now rents are starting to rise even though moratoriums remain in place. Rents were further depressed by the migration from urban apartments to suburban home ownership. Postponed rent hikes caused a "transitory" reduction in CPI. Home prices aren't directly considered when calculating inflation, but they still matter. Rents follow home prices and building costs by about a year. When those moratoriums are lifted in September, rent hikes will accelerate. Most landlords will be reluctant to risk a sudden rash of vacancies with double digit rent hikes. Rents will still be catching up well into 2023. Nothing says inflation like rising rents. Medical costs are also poised to rise rapidly. Patients are returning to hospitals and doctor offices for procedures that were postponed during the pandemic. Hospitals still have almost $200 billion in Covid relief funds that have yet to be spent. Rising medical costs may be under represented in the CPI but still contribute to inflation. Medical costs are a much bigger part of the PCE deflator. Unlike the CPI, which targets current medical prices, the deflator relies on Medicare reimbursement rates. Those reimbursements don't change in lockstep with price hikes and can lag actual price hikes by months or even years. Idiosyncrasies like these are why the various indices report different monthly inflation rates. In any given month one index will be more representative of shifting consumer preferences than the others. Over very long periods the various indices tend to track. This year's inflation will impact both cost of living adjustments and the contracts that drive next year's inflation rate. Businesses burned by this years shortages will be willing to accept higher prices for deliveries next year. Over 50% of American households are scheduled to get a big pay raise in January. All government workers and Social Security recipients get an adjustment based on CPI through October. Unless inflation retreats significantly over the summer, that increase is likely to be around 4%. Consumer prices will continue to rise at a pace closer to 4% than 2% through 2022. We may have to start defining "transitory' in terms of years rather than months. The recent 9% annualized rise in consumer prices will slow in coming months but remain elevated. In March I suggested the cumulative expansion of money supply over the past few years would push CPI above 4%. That forecast may prove optimistic.

IT'S TIME FOR THE FED TO DECLARE VICTOR

The stated mission of the the Federal Reserve is to achieve full employment with low inflation. Inflation remained slightly below 2% for most of the past decade, but unemployment was substantially elevated in a number of those years. A few years back the Fed abandoned its efforts to preemptively contain inflation. Priority shifted to job creation. The economy is at or near full employment and prices are rising rapidly. It's time to declare victory. Recent FED actions suggest they may have already done that while officially denying any policy change. Traditionally the Fed provides stimulus by flooding the banking system with excess reserves. Those excess reserves encourage lending. Increased lending always stimulates growth and/or inflation. That process broke down in wake of the the financial crisis as loan losses and increased regulation restricted lending. Loan growth remains anemic, despite a banking system awash in excess reserves. Default fears in the wake of last year's shutdown and the subsequent ability of corporations to raise money in the bond market at low cost aggravated the lending drought. Deficit spending replaced bank lending as the the primary driver of growth. This accelerated dramatically last year. The Fed has facilitated the deficits by purchasing half of all outstanding Treasury debt with money it created out of thin air. It expanded that process with $80 billion in monthly TBond purchases. They also financed the housing boom with monthly purchases of $40 billion in mortgage backed securities. These purchases have kept long term rates artificially low. Those deficits fueled unprecedented double digit growth in personal incomes and spending last year despite an economic contraction of 3.5%. Similar to the lending debacle, the historically tight link between jobs and spending was broken. 30% of US personal income came from government handouts. GDP is quickly recovering, but 7.5 million fewer Americans are reporting to work. Although employment and growth soared (GDP up 1.6%-6.4% annualized) in Q1, real GDP was still slightly below the previous peak. Inventories were depleted and imports soared but still fell short of the 23% year over year rise in retail sales. As inventories disappeared prices rose. Since then, inflation has accelerated. CPI increased at an annual pace of 7.7% through May up from 7.4% in Q1. Consumer spending remains strong but those price hikes and shortages are slowing sales and growth. According to IHS Markits widely watched estimate, growth in April and May decelerated about 40% from the pace in Q1. They estimate annualized growth for the first 5 months has dropped to a 5.3% rate (vs 6.4% in Q1). When you adjust for inflation, consumer spending has declined. Six weeks ago Chairman Powell and other board members were still assuring us that the Fed was not "even thinking about thinking about" tapering those purchases. Recently a couple of board members have hinted that they might want to reconsider that decision. Former Fed Chairman (now Treasury Secretary) Yellen recently hinted that higher rates may be on the way. Are they waking up and starting to smell the inflation? Whether or not you believe the FEDs inflation concerns are growing, the need for bond purchases has diminished. Tax receipts are soaring and most of the stimulus money has already been handed out. Bidens $4+ Trillion dollar spending package now appears to be DOA. Spending in Q1 means 2021 deficits will be at or near 2020s record levels, but in the last couple of months the deficit is shrinking. The Treasury doesn't need to sell so many bonds. At $80 billion per month, Fed purchases exceed the current cash needs of the Treasury by billions. A month ago investors universally believed bigger deficits and higher rates were inevitable. That anticipation fueled big short positions in TBonds that pushed rates up. The Biden administration's failure to garner the votes for the spending package changed all that. After the checks went out in late March spending fell dramatically. Consumer spending followed suit and growth slowed. Investors continue to believe that the Fed is unconcerned with inflation they consider "transitory" but concern over slowing growth will keep inflation expectations and rates low. That shift in perception squeezed those short positions in bonds reducing 10 year TBond yields over 1/4% from recent highs. The shrinking deficit is clearly transitory. Tax receipts will decelerate as growth slows and spending will will jump after year end as the cost of living hikes kick in. rising inflation expectations. Simultaneously they wage a stealth attack on excessive money growth that is driving prices higher. Consider the following efforts to contain expectations in light of the ancient French proverb "nothing is confirmed until officially denied".. 4

The Fed (continued)

The Fed abandoned its preemptive efforts to contain inflation a few years ago on the theory that price hikes are driven primarily by inflation expectations. Until recently inflation expectations seemed centered around the FEDs 2% target. Inflation is now soaring in response to excess monetary creation. Expectations are rapidly catching up with the recent price hikes. Powell and company continue to assure us that inflation is "transitory" and rate hikes aren't coming any time soon. In the words of the ancient French proverb "nothing is confirmed until officially denied". Investors appear placated. but consumers clearly have their doubts. The best estimate of consumer expectations is a survey done by the University of Michigan. According to that survey consumer expectations are rising about twice as fast as investor expectations as measured by the TIPS spread. The TIPS "spread" compares conventional TBonds with Treasury Inflation Protected Securities (TIPS). That spread is considered the best measure of investor expectations. Professional investors watch the spread to gauge the expectations of other investors. As the worlds biggest TBond buyer, the FED can manipulate that spread. Reducing TIPS purchases (as they have recently done) will narrow the spread falsely implying that investor inflation expectations have retreated. Artificially reducing the TIPS spread seems to be working. Investors continue to price virtually all asset categories as if inflation "transitory". Years of Fed monetary expansion have caused bank deposits to soar, while loan demand remains weak. That mismatch has kept interest rates way below the rate of inflation. Recently, banks awash in cash from the cumulative effect of FED money printing have begun telling big corporate depositors " we don't want your money". Despite denials, the Fed is very aware of this surplus and its' long term ,inflationary consequences. They have quietly been draining a lot of that excess liquidity with daily a Reverse Repurchase ("reverses") program. "Reverses" drain cash by "selling" bonds to the banks and while agreeing to quickly "repurchase" them. In the current environment this provides numerous short term benefits. In the last month that program has risen to record levels approaching $500 billion dollars. This reduces excess liquidity without clearing indicating a transition to higher rates in the way that a reduction in the monthly bond purchases. Banks get rid of excess cash. The bonds sold to the banks through "reverses" can be then lent to the short sellers mitigating the severity of the "short squeeze. All the while the Fed maintains the illusion of ever expanding liquidity while actually reducing money supply growth. M2 money growth has slowed from last years hyper-inflationary 25% rate to below 15% in April. Increasing the "reverses" has certainly slowed money growth further but we don't get the May data for a few more weeks. The Fed has stared tightening, but banks have so much excess cash that rates are not rising YET! It is crucial to remember that monetary expansions and contractions impact economic growth quickly, while the impact on consumer prices is spread over a few years. The FED is ill equipped to reduce inflation without raising rates enough to trigger a recession.

CONCLUSIONS

For the last few years we have argued that expanding deficits financed by the Fed would inevitably lead to significantly higher inflation. This years rebound produced high single digit annualized growth in real GDP, inflation and employment. Gains in employment and output are typical of recoveries from recessions, sharply higher inflation is not. Almost everyone (including myself and the Fed), predicted that prices would be lot higher than a year ago during the shutdown. In addition to the "transitory" statistical rise in consumer prices, the longer term inflation pressures caused by excess money creation that I forecast have appeared a lot sooner than even I expected. The US has run out of workers while shortages of goods and materials are reported worldwide. Over time those shortages will disappear as price increases trigger both reduced buying and increased production. It will however take huge wage increases or a lot more immigration to alleviate the worker shortage. Employees are quitting at a record pace while layoffs are at an all time low. It all adds up to rising costs for business and higher prices for consumers. Those price hikes are aggravating the impact of shortages on growth. Shortages are slowing the rate of growth, not causing it to contract. Production is rising not falling. The three month decline in existing home sales during the last three months can only be explained by the negative effect of rising prices. How else can you explain slowing sales in the peak selling season, while mortgage rates rates remain near record lows and wages are rising? Shortages are slowly abating but growth is slowing as rising prices reduce purchasing power. Don't expect these trends to change any time soon. Few stock and bond investors seem to share my concerns. For them the only consideration is whether the FED is poised to hike rates. They seem confident that slowing growth will prevent rate hikes and "transitory" inflation will quickly disappear. In the very short term rates are unlikely to rise. The economy remains flooded with sufficient cash to support both rising inflation and record stock prices. Contrary to the prevailing view of "transitory" inflation, excess liquidity is fueling a rising inflation trend. Recent actions to drain liquidity stealthily indicate the FED is starting to consider ongoing inflation to be a real threat. Although the Fed hopes to avoid it, growth will slow further and rates will rise as the excess liquidity is absorbed by FED withdrawals and rising prices. As the combination of slowing growth and rising inflation becomes widely recognized the bubbles in the stock and bond markets will deflate. Long before inflation drops back below 2% the economy will sink into recession. The FED will try to avert that outcome by keeping interest rates below the rate of inflation. As long as that negative interest rate environment exists in a slowing economy investments like precious metals, real estate and TIPS will outperform. Consumer prices are likely to rise around 4% this year way above most forecasts. Growth will slow below 2% late in the year, reducing 2021 real GDP gains below 4%.

Sincerely,

Clyde Kendzierski

FINANCIAL SOLUTIONS GROUP LLC

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