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Since our last review in January of 2022, many things have changed in the economy. GDP growth has turned negative in the first two quarters of 2022 (which officially puts the economy into a recession). Inflation is now the highest it has been since the 80’s, yet unemployment is back to pre-COVID years. With these conflicting indications, the question becomes what does it all mean and what to expect?
Usually, inflation and unemployment move in opposite directions. For example, when everyone who wants a job has a job, employers have to compete for workers and raise wages. This increase in wages drives production costs higher resulting in higher price tags for the consumer. At the same time, workers that receive higher wages can afford to buy more goods and services. That increased demand, obviously, also leads to higher prices. All of this usually occurs in periods of high GDP growth, because where else would all those jobs come from if not from increased production.
That is how the economy works in normal times.
The last time high inflation and falling GDP were observed (also known as stagflation) was in the 1970’s. Stagflation at that time was due to oil shocks created by political instability in the Middle East. The oil shocks in the 70’s demonstrated that prices can go up while unemployment increases and GDP falls. Today, because of the events around Ukraine, prices of oil (and many other items) have increased significantly. Typical consequences of this should include high inflation, low or negative GDP growth - which we are observing - and high unemployment - which we are not observing - or at least not yet. Rather, present demand for workers still outstrips the labor supply. In addition, unlike during the 1970’s oil shocks, recent oil price increases happened right after worldwide quarantines and economic slowdowns adding to already high levels of inflation caused by supply chain disruptions and monetary easing. So let’s look at each of these factors and discuss what caused the changes and where we are possibly headed.
GDP
GDP contraction is something to be expected with rising interest rates. The Federal Reserve Bank has been raising rates drastically at each of their meetings since March of 2022. This, obviously, should make all other interest rates higher and credit for any projects - from buying a house to building a new plant or investing in inventory – more expensive. We can see some effects of it already - for example, the graph below shows sales of existing homes in the USA. Clearly, there is a significant slowdown in residential real estate markets.
While overall consumer spending stays strong, growth has stopped. Below is the graph of real personal consumption expenditures. It is very clear that consumption has “flattened out”. The likely reason for this is two-fold 1) increasing interest rates, and 2) dissipation of the “rage consumption” effect that came as a result of the 2020 lockdowns. During the lockdowns, people postponed many things they wanted to do like traveling, weddings, parties, etc… When the lockdowns were lifted, the consumer began spending again with a vengeance.
Inflation
Of course, slowing down demand should cause price stabilization. But as we can see from the previous section, the slowdown in consumption is very recent and we have yet to experience a majority of the effects. Consumption is the largest portion of GDP, thus changes in consumption have very strong impacts on the overall economy. According to the U.S. Bureau of Labor Statistics August 10th release (1), the headline consumer price index was unchanged in July, leaving annualized inflation on all items at 8.5 percent; however, if one digs deeper into the report, it is clear that the slowdown in price growth is the result of a July decrease in the energy price index of 4.6 percent.
On December 1, 2021, the front month West Texas intermediate crude oil contract was trading at a 12-month low of $65.57/barrel. Prices slowly marched upwards to $92.10 a barrel the day before Russia’s surprise invasion of Ukraine. They spiked as high as $123.70 two weeks after the invasion amidst Western sanctions, before slowly settling back down to the low $90’s today. For a litany of reasons, over the last decade, companies have been reluctant, unwilling, or unable to make investments in oil and gas development resulting in today’s higher prices and increased volatility. Because of these supply constraints, energy volatility is likely to increase in the short-term, making the Central Bank’s job that much more difficult.
In July energy prices happened to go down; however, no one can guarantee that these prices won’t rise again soon. It is too early to state that inflation is getting under control. Food inflation in July was 1.1 percent (an annualized 10.9 percent), and all items excluding food and energy went up by 0.3 percent in July (an annualized price increase of 7 percent).
At this point the Fed is continuing to increase interest rates and reduce the size of its balance sheet (2). This should tighten economic activity some more and that will slow or stop inflation. Of course, this comes at the cost of a decrease in aggregate demand in general and consumption in particular. Translation: decreased GDP.
Unemployment
According to the August 5th BLS data release (3), the unemployment rate is now down to 3.5 percent with the number of unemployed down to 5.7 million which is close to pre-pandemic levels. The labor force participation rate is now 62.1 percent (slightly lower than pre-pandemic 64.4 percent). With these numbers, the labor market is very tight and many employers still have a hard time hiring people. One explanation for this comes from everything we discussed above - parts of aggregate demand are still strong or only slightly slowing down, causing more jobs to be created. July’s job gains were most noticeable in the leisure and hospitality, professional and
business services, and health care sectors (3). Clearly employers in these areas see demand for their goods and services (why hire otherwise). Once increased interest rates take full effect, demand for different goods and services will fall which would cause a loosening in the job market, meaning more candidates for each vacancy.
Another big reason for the tightness of the labor markets is changes in workers' preferences. The pandemic has changed how many workers choose to work (remote, flexible schedules, etc…). Jobs that do not have that option are less attractive. Why cook the meal at a restaurant under your boss’ watchful eye and with a tight schedule of shifts when you can deliver that meal with Uber eats whenever you feel like working? Once the effects of increased higher interest rates ripple through the economy, unemployment will increase. We already see that GDP is falling. Unemployment is generally a lagging indicator for GDP, so it takes a bit more time to see the effects.
Recommendations
1) Perhaps the biggest question now is whether or not a business should increase their prices. Obviously, in the time of inflation, all prices go up – which leads to increase in costs and decrease in profit margins. So should one pass these cost increases onto their consumers? The answer to this question is - of course - “it depends”. Most businesses operate in a monopolistically competitive environment – meaning goods are somewhat differentiated, many substitutes exist, but these substitutes are not 100% perfect. In this environment building brand loyalty is key. Drastic price increases can make customers switch to other brands. Let me make an example - the author of this review really enjoys coffee. One local shop sells good quality whole beans for $19.99 a pound. Recently, the shop has changed the price to $24.99 (a 25% increase while, according to BLS, yearly inflation on roasted coffee is 3.2%!!! (4)). Well, it seems like it is time to go find another coffee supplier. Every time the price goes up, the quantity sold decreases. So the question is always which effect will be stronger. Coffee in this shop is a luxury good with many cheaper substitutes available – this will make the quantity effect stronger. Even if the prices are later decreased, the damage is already done. It will take years to rebuild the customer base. So price increases are inevitable, but they have to be carefully calculated.
2) Based on the economic situation, it is reasonable to expect more candidates for job openings. As the labor market loosens, many businesses will go back to in-person work, removing the possibility of remote work in competition for job seekers. As Elon Musk put it:
“Anyone who wishes to do remote work must be in the office for a minimum (and I mean *minimum*) of 40 hours per week or depart Tesla” (5).
There are only so many Uber drivers needed. The more people who join that pool – the less money each will make. Once they start experiencing the full effect of that, many jobs that were losing to more flexible alternatives will be filled.
Thank You!
Rita George
Managing Partner
Clement George
Managing Partner
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