With Economy Running Hot, Some Sectors Will Get Burned

08/31/2021: Faced with resurgent demand fueled by a high-octane blend of pandemic fatigue and government checks, monetary policymakers are letting the economy run hot. At last reading, Q1/21 GDP expanded at a 6.4 per cent annualized rate, powered by 7 per cent growth in personal consumption. Despite the pyrotechnics, market participants don’t expect the Federal Reserve to raise rates until sometime in 2023. Fed Chairman Powell last week at the Jackson Hole virtual summit successfully argued that tapering isn’t tightening. Even though Powell articulated the Fed’s plan to begin cutting its monthly $120 billion bond purchase program by year end, equity investors cheered.

Federal Reserve policy toward inflation has shifted over the last few years, from cautious and preemptive to a laissez faire, “let it run hot” stance. Their rationale appears to be manifold. The first reason: history. The Fed has been emboldened by its ability to keep a lid on inflation over the years.  Year-over-year inflation peaked at 14.3 per cent in 1980 and has cascaded downward through a series of lower highs and lower lows since then. Arguably, secular slowing, not Fed policy, deserved most of the credit for this. Meanwhile, the Fed’s ability to maintain inflation at its 2 per cent target since the financial crisis has been dismal.

The second reason: a pedal-to-the-metal monetary policy is good for American workers, particularly those on the bottom rungs of the income totem pole. The Fed believes higher inflation in the near term could lift more people out of poverty over the longer term. This new perspective is predicated on two observations. First, recessions tend to hurt unskilled, low-wage workers more than the well-off. Last year’s pandemic-induced recession was a clear example. Going into 2020, the numbers of Americans holding jobs in manufacturing and food service were roughly equal. However, between February and April last year employers slashed nearly 6 million food service jobs but only about 1.3 million manufacturing jobs. The Fed argues that over the years certain prices, like those for education and medical care, have grown far and away faster than lower-income wages, and that these services represent a greater share of household expenditures among lower-income households.

Recent data suggest that idea holds water. Wages at the lowest end of the pay scale have been growing quickly and job openings are abundant. As of July, the average hourly wage of leisure and hospitality workers was $16.47/hour – more than double the growth of wages overall during the last 12 months.  Meanwhile, employers have over 10 million job openings, with nearly 2 million in leisure and hospitality. Overall, there are currently more job openings than workers willing to fill them.

More spending is on the way. The Senate passed a sweeping, $1 trillion bipartisan infrastructure package on August 10 and it is increasingly likely the Democrats will also pass President Biden’s $3.5 trillion spending package in the coming weeks. The combination of fiscal spending and easy money will ensure jobs are abundant and wages will rise. Productivity will undoubtedly fall in response. Think of the labor market as a pickup soccer game: as the two captains pick sides, the most productive players will be snatched up first, leaving the least-talented players to be chosen at the end. At some point, the job market will become too tight and the least-productive workers will enter the labor force, creating service problems and margin pressure on their employers. While robust growth is great for lifting all boats, pay attention to labor-intensive businesses that must compete for unskilled workers. Employers will be motivated to innovate with technology to offset the higher costs and lower productivity a tight labor market brings. In the short run, however, they could get squeezed. Focusing on sectors with high market caps per employee, like communications, technology and utilities, tends to single out high- valued-added or capital-intensive business that generally don’t rely on a large, unskilled workforce.  Consumer discretionary and consumer staples could see their margins squeezed with higher wages.