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As seen on Forbes.com 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 1 of 2 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 Investment products are: NOT FDIC INSURED • NOT BANK GUARANTEED • MAY LOSE VALUE • NOT A DEPOSIT • NOT INSURED BY ANY FEDERAL OR STATE GOVERNMENT AGENCY This material is presented for informational purposes only and should not be construed as individual tax or financial advice. KeyBank does not provide legal advice. ©2017 KeyCorp. KeyBank is Member FDIC. 170410-219438 2 of 2