High-pressure labour markets and 2 cycles

At last week’s press conference Fed Chair Jerome Powell several times emphasised the benefits of high-pressure labour markets in drawing marginal workers into the labour force. Older workers, low-skilled workers, those with convictions or addictions and those who have been out of work for a long time often can’t get jobs unless unemployment is very low. And marginal workers are a hot-button issue given the general soul-searching about the ‘left behind’ since Trump’s surprise election in 2016 as well as the strong focus on tackling inequality among Democrat Presidential hopefuls. But what does a high-pressure labour market mean for the US economy?

I want to argue in this post that it is generally positive for extending the current economic cycle (the usual 9-11 year cycle), but it likely will bring higher inflation before long. And it just might have implications for another cycle, the 60-year Kondratieff cycle which, though treated with great scepticism by most economists, predicts a rise in inflation over the next 10-20 years. More on Kondratieff later: First the current ordinary cycle.

As I have argued several times in recent weeks, the good news is that after 10 years of upswing (from July 2009) there is still no sign of serious overheating nor wild risk-taking. I put this down to a combination of balance sheet restructuring, European and (recently) China weakness, fiscal tightening and just general caution following the traumas of 2008-9. All this kept growth modest for most of the last 10 years, except for the surge in 2018 attributable to tax cuts. But unemployment has come steadily down and on the broad measure called U-6, which picks up many of those out of jobs for the reasons listed above, is already quite low.

With the economy having slowed the Fed is quite right to be on hold, and to be willing to move either way, though I rather doubt they will need to cut. But the significance of the Fed being willing to welcome high pressure labour markets, and to ‘run the economy hot’ and to regard above-target inflation as acceptable for a while, is that the US almost certainly will see inflation rise eventually.

Right now inflation is running at about 1.6%, below target, and we know the Phillips Curve is fairly flat, so it will likely take at least 18-24 months for inflation to pick up to 2.5%, assuming that the economy does run hot. How hot is hot? Well, given the demographics, GDP only needs to grow about 1.5% annually to keep unemployment stable. Anything more than that will see the unemployment rate decline further, unless productivity does better than I expect. In Q1 growth in output per hour in the business sector reached 2.4% over a year earlier but I doubt that is sustainable. Long story short – if the Fed succeeds in generating economic growth much above 2%, with or without a rate cut, unemployment will drift lower. Eventually inflation will respond.

The Kondratieff cycle

What about the Kondratieff cycle? I hesitate to even mention it because most economists give it such short shrift. They say, quite correctly, that it is based on only about 4 cycles since there is very little data before 1800. But I do take it at least a bit seriously because when Nikolai Kondratieff wrote in 1925 he made what turned out to be the most startingly accurate long term forecast of all time!

His study identified a price cycle, not an output cycle. He assumed, as do most economists, that prices and output are related but attempts by him and others to find a 50-60 year cycle in output struggle. I prefer to think purely in terms of prices. Kondratieff suggested that prices go in a 50-60 year cycle with 20-30 years of acceleration and 20-30 years of deceleration. He identified 1896 as the beginning of an acceleration period and 1919-21 as the peak. So, fast forward 50-60 years and you get 1970-1980 as the next peak. You have to admit that was a great forecast! US inflation (core PCE) hit 10.2% in 1974 and 9.8% in 1980. The UK had it much worse with the RPI all items peaking at 26% and 22% respectively.

If we take 1974 as the recent peak, then the next one is due in 2024-34. If we take 1980 then the peak is a few years later. Strictly speaking we should be seeing a 20-30 year build-up but if it turns out that 2010 was the inflation low (see chart) we could be on track.

This takes me back to the Fed welcoming a high-pressure labour market. It is laudable in many ways – I agree. But it could easily lead to accelerating inflation over time. It could be that in 20 years time people will recognise that just as policy-makers in the 1960s and 70s tolerated slightly higher inflation (each year!) because they desperately feared repeating the unemployment of the 1930s and its resulting political turmoil, perhaps policy-makers today will make the same mistake for fear of the same thing.

Predicting a new peak for inflation of course says nothing about how high it could be. US core inflation hasn’t been above 2.5% since 1994 so the peak could be ‘only’ about 3-4% and still count. And it also doesn’t explain how we might get there in terms of the ordinary 9-11 year cycle. One way would be for the current cycle to be unusually long so that inflation creeps inexorably up before giving us the forecast peak sometime in the mid-2020s. Another is that we do see a recession sooner, which will initially take inflation lower, but that the central bank response to get us out generates a much higher inflation rate down the road. Think negative interest rates or helicopter money. Neither Kondratieff’s crystal ball nor mine is good enough to say which will be the outcome. But if you accept even the possibility that there is something to the Kondratieff cycle, be ready for inflation to return.