- Macro Strategist
Spain, Institutional
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The tight US labor supply has been a defining characteristic of the current US expansion and it colors the near-term outlook for inflation and interest rates. But labor dynamics will also be a critical long-term story that affects a wide range of economic and financial market outcomes. The point at which labor demand and supply find their equilibrium and the ways in which wages interact with a tighter labor market will, for example, have a meaningful impact on which sectors and companies outperform the equity market in coming years.
The US labor situation will be an ongoing area of focus in my research, and I would like to highlight a few of my initial conclusions up front:
- Shifting demographics imply tighter labor markets over the course of the cycle and, in turn, higher real rates.
- Scarce labor coupled with skill mismatches will result in rising real wages and a push for more automation and investment spending.
- Workers stand to gain new bargaining power, which could reduce income inequality across the US economy. Wage-growth compression could occur as automation puts downward pressure on incomes of higher earners while a decline in the number of lower-skilled workers stabilizes incomes for blue-collar workers.
- Shifting demographics will prompt governments to focus more on labor and investment policies as these areas become a political battleground. This phenomenon is increasingly global, and the relative winners in the coming decade could well be the countries that best calibrate decisions around labor (e.g., immigration policy and dependent care) and investment (e.g., R&D expenditures and technological advances). This also comes at a time when reshoring and focused industrial policies are reshaping supply chains around the world.
US demographics in perspective
With the large baby boomer generation now retiring and being followed by the smaller Gen X and the elongated profile of Gen Y and Gen Z (i.e., Gen Y and Gen Z are large but births were spread out over a long period), I expect relative labor scarcity to be one of the enduring themes of the next decade. Of course, the US is not alone in facing such demographic challenges — and in fact, it is better off than some other major economies in terms of the working-age population, thanks in part to a recent boost in the prime worker population from Gen Y. But the long-term trend reflects my view that this theme will endure (Figure 1).
Figure 1
In addition, the US, long upheld for its flexible labor markets and high participation rates, is now at the lower end of G20 nations for both male and female labor force participation rates (Figure 2). Among men, this decline is explained by a confluence of factors, including the opioid crisis, rising incarceration rates, and declining education rates. Among women, the shift can be tied to pandemic-related effects (e.g., more women stepped away from work to care for ailing family members) and the rising cost and scarcity of childcare. Inflecting these numbers back in a positive direction will require the right mix of policy and investment.
Figure 2
The broader implications of a tight labor market
- More power to the people — After a long period of losing power to corporations, workers could gain some traction in the coming decade, with a tight labor market potentially helping to lift the labor share of output (the percentage of economic output that accrues to workers in the form of compensation) from the record lows of recent years (Figure 3). This would help reverse some of the hollowing of the middle class that was a dominant theme of the last 25 – 30 years, driven by China’s entry into the global economy and by deep “balance-sheet recessions” that left unemployment elevated and workers in a vulnerable position.
When China entered the WTO in 2001, the resulting addition of 100 million workers to the global labor force was a seismic event that lowered wages across the manufacturing sector in developed countries and exacerbated job losses in a downturn. But today, the Chinese labor force has peaked and is projected to shrink over the next 10 years (Figure 1), a shift that will add to the bargaining power of developed market workers. The developed world has begun to reroute factories to Mexico, India, Vietnam, Indonesia, and Thailand, among other countries, but this one-time positive shock to global labor supply is unlikely to be replicated in the decade ahead.
If the balance of power is shifting to workers, real wage gains should provide resiliency to lower-income households. This, coupled with a higher cost of capital, which limits market gains for higher-income households, could mean that US income inequality will finally begin to peak.
Figure 3
- The shrinking pool of lower-skilled labor — Another factor that could help reduce income inequality: The share of the working-age population without a college degree continues to shrink, meaning that unless immigration picks up materially, somewhat higher wages are likely to be the norm in lower-skilled jobs. This could also help improve employee retention rates in lower-skilled industries that have recently struggled with high attrition and poor productivity. For their part, workers with higher education may see more downward pressure on wage growth from the adoption of automation and AI.
- Automation as an ally — As noted at the outset, higher wages bring with them an incentive for companies to invest in tools and technology that can help reduce their labor costs. This could be meaningful for productivity in the years ahead, following a long period of anemic capital spending in an era of labor abundance.
Automation, which has been looked at with suspicion in weak employment environments, is likely to gain scale. This will be most evident in labor-intensive industries that also got an automation boost during the pandemic, including retail, leisure and food services, health care, and professional services. In these industries, the continued uptake of automation will be a key driver of higher growth in the future.
Thus far, automation has generally been favored by companies hoping to boost productivity. This matters because wage gains supported by higher productivity allow for gains in both profits and consumer demand. My bias is that automation technology will be adopted by a broader set of companies across the economy.
- Creative destruction on the rise — In 2021 – 2022, we saw one of the biggest jumps in business formation in US history (Figure 4). This suggests that some workers shifted to self-employment and, in turn, boosted demand for labor to support their new enterprises. Five areas accounted for the bulk of the gain: online retail; trucking and warehousing; professional, scientific, and technology services; administrative support; and personal services. Now, amid higher interest rates and normalizing demand, I think we should expect some of these businesses to fail, boosting the supply of labor somewhat. In short, a higher cost of capital weeds out weaker companies while new business formation driven by technological innovation encourages the process of creative destruction.
Figure 4
- A vigilant Fed and higher real rates — As mentioned, the labor share of output may rise in coming years. But it is noteworthy that for all their tightness, labor markets have not yet driven a wage-price spiral, as evidenced by declining real wages in the US in 2022. This would seem to dispel comparisons between today’s inflation environment and what we witnessed during the 1970s. However, the Fed will certainly stay mindful of the possibility of a wage-price spiral and will not let up until it is convinced that disinflation has gained the upper hand. This means that even when it is done hiking rates, the Fed will remain vigilant until the inflation rate is closer to target and/or the unemployment rate turns up meaningfully. I would expect higher real policy rates over the course of the expansion.
Policy levers that can make a difference in a tight labor market
As a starting point for US policy, there may be a lot to learn from Japan, which grew its labor force over the past decade despite a rapidly shrinking working-age population. Among the tactics that proved effective: encouraging more women to enter the workforce by offering better, more affordable childcare, introducing flexible work arrangements, and removing disincentives such as a low retirement age. Addressing the cost of childcare, in particular, would move the needle in the US, where it tends to be far more expensive than in other parts of the developed world. The demand for solutions is so strong that it would not surprise me if, in the runup to the next US election, a renewal of the recently expired child tax credit ends up being endorsed by both parties (if it comes with a work requirement).
To the list of possible policy solutions, I would add improving elder care affordability and availability, expanding workforce training, and finding ways to bring those previously incarcerated or recovering from opioid addiction back into the labor market. Whatever the focus of the proposed solutions, careful policy design will be critical to ensure that workforce participation is incentivized.
Lastly, a greater willingness to open US borders to immigration could help mitigate the labor-market impact of an aging society. We saw an example when, after the COVID-driven hiatus in immigration, an influx of some one million immigrants helped ease the US labor supply/demand imbalance a bit. The importance of this incremental supply is visible in wage gains, which have started to moderate at the lowest end. For instance, immigrants account for 31% of the labor force in the hotel and lodging industry1, which saw some of the biggest wage increases in 2022 and some moderation recently. Looking ahead, the current backlog of 389,000 visas2 suggests room for another boost in immigration, which would be welcome news.
The relative scarcity of labor is likely to be an enduring theme given the shift in demographics, skill mismatches, and reshoring of supply chains. Going forward, I expect the focus to be on higher investment spending and higher real rates, as well as the possibility of more power ending up in the hands of workers. Policy likely needs to be more active in this area to find winning solutions.
1Source: National Immigration Forum | 2Source: US Department of State, June 2023
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