Download Why You Need To Worry About The Return Of Stagflation

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Why You Need To Worry About
The Return Of Stagflation
April 2017
by Bruce McCain, Chief Investment Strategist, Key Private Bank
To combat recession, monetary authorities reduce interest rates to stimulate growth. To fight inflation, they raise rates to
reduce growth. But what if they need to do both at the same time?
When economic stagnation and inflation occur
even the emerging markets suffer from excess capacity
simultaneously, tools that ease one problem make the
and are experiencing slower economic growth.
other worse. The 1970s taught us that “stagflation”
At the same time, as emerging markets production
can be especially hard to combat. For that reason, we
should be concerned that changes occurring in our
labor force make stagflation significantly more likely
than it has been in nearly 40 years.
expanded, firms in the developed markets slashed labor
costs to remain globally competitive. Automation and other
means of increasing productivity made U.S. firms more
cost effective but also slowed consumer income growth.
The point at which supply meets demand defines the
With consumption responsible for roughly 70% of the
output of an economy. Typically, however, one side of that
developed economies, reduced consumer income growth
balance is more limiting than the other. That imbalance
slowed the growth of economic demand even more.
determines the type of growth cycle we experience.
The overcapacity of production had some beneficial effects.
Over the last several decades, the supply of manufactured
Heavy supply relative to demand holds prices down,
goods has expanded much more rapidly than demand,
limiting inflationary pressures. We avoided the deflationary
which made a shortfall of product demand the defining
pressures that some feared, and the ample supply of goods
global economic constraint. Falling capacity utilization
helped keep the overall inflation rate low.
rates around the world document the effect of limited
If a lack of demand defined the economy over the last
demand. In the United States, utilization peaked at around
92% during the economic cycles of the 1950s and 1960s.
Since that time, we have peaked at a lower rate in each
successive cycle, hitting a utilization rate of only 79%
during this expansion.
few decades, major labor shortages seem much more
likely to define the coming decades. In the 1970s and
1980s boomers caused the working population to swell
as they entered the labor force. As that generation
retires, the proportion of the population still working will
Globalization has been a primary driver of overcapacity
shrink dramatically.
in the developed economies. Financing was plentiful
In 2010, the number of U.S. workers in their prime
and manufacturers expanded overseas facilities to take
advantage of cheaper labor costs, rather than as a
response to rising global demand. In the last few years,
global overcapacity has reached a tipping point, where
working years outnumbered those 65 years and older by
a ratio of 4 to 1. In 2040, that ratio will be cut almost in half,
to roughly 2.3 to 1. The same demographic effect is also
occurring in most other developed countries and some
of the emerging markets.
Why You Need To Worry About The Return Of Stagflation
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A severely limited labor supply has a profound effect on
Rising wages would allocate scarce workers to firms that
economic growth. At current rates of labor force growth
bid the most, but would not expand economic output unless
and productivity improvement, workforce improvement
higher wages attract new workers or increase productivity
would only support a growth rate of just over 1%.
of the workforce. In a tightly constrained economy, labor
Although labor shortages can be offset by improved
inflation could occur with little or no additional economic
productivity, it takes time to develop technologies to
accomplish that. Bear in mind, too, that productivity would
output. In other words, a labor constrained economy has
a much higher risk of stagflation than one that is limited by
need to improve markedly to fully offset the dramatic
inadequate demand.
decline that will occur in the workforce ratio. It seems
Economies have a remarkable ability to resolve constraints,
unlikely that productivity gains can fully offset the limitations
and several things might help ease labor shortages.
of a drastically smaller proportion of workers.
Improved productivity and people extending the years
Increased immigration could also help alleviate part of the
they work could help to mitigate labor shortages, as would
shortage, although that carries with it a complex set of
unique challenges and considerations. We would still need
a very large inflow of new workers to fully compensate for
the impending shortfall. Moreover, even if a large number
of new entrants came, it would be challenging to get the
immigration policy that enhanced U.S. labor capability.
Given the radical demographic shift that will occur, however,
it seems unlikely that the economy can fully escape major
labor shortages. In all probability, the impending labor
shortfall will both limit economic growth and increase
right mix of skills and training.
inflationary pressures. That could be a recipe for stagflation.
Substantial supply shortages also have major inflationary
For more information or questions, please
contact your Key Private Bank Advisor.
implications. Firms that are limited by the decreasing
availability of labor would almost certainly bid wages
higher in an effort to attract and retain the employees they
need. While that might encourage some baby boomers to
work longer, that too would likely fill only a small part of the
critical needs.
About Bruce McCain
Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the
financial markets and serves as part of the team that formulates investment strategies for clients. He supplies
frequent insights to media throughout the region and around the country. His comments and interviews have
been featured in such publications as The New York Times, The Wall Street Journal, Investor’s Business Daily,
and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular
source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com. Bruce
joined a predecessor of Key in 1987, after spending six years on the business faculty of the University of Iowa’s Henry B. Tippie College
of Business. Bruce earned a PhD in Business Administration from the University of California at Berkeley, and undergraduate degrees in
Psychology and Accounting from Boise State University.
Why You Need To Worry About The Return Of Stagflation
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