Part I: No take-off, no landing - a tale of two unprecedented shocks

By Jean Boivin and Alex Brazier | This is a macroeconomic environment the like of which we have never seen before. This should temper the temptation to think it will play out in the “usual” way. The U.S. is navigating two large and unprecedented shocks. The first is a mismatch: a massive, pandemic-induced shift in consumer spending — most visible from services to goods – created a mismatch in what the economy was set up to produce and what people wanted to buy. The second is demographics: a worker shortage has emerged as baby boomers age into retirement.

Historical episodes do not provide a guide to how – and over what time frame – the mismatch and demographic shocks might play out. That means not only that the outlook is uncertain, but that we are also unusually uncertain about where we are right now. So, incoming information on inflation, growth and labor market dynamics is even more crucial than usual and we have seen the dominant narrative among policymakers, economists and markets flip several times this year.

In this first part, we reassess where the economy’s at. In part two, we consider where we think it might be going in light of recent data. Bottom line? We have learned that the two shocks are playing out over different time horizons to each other and in part from what we expected.

The demographic shock is only just starting to bind because, looking closely, the economy has flatlined for 18 months. Some of the growth damage we expected from the Fed’s rate hikes has probably already happened. An outright recession is still in the cards. But, more importantly, we expect the economy to broadly flatline for another year, making it the weakest two-year growth stretch in the post-war era, aside from the GFC. Inflation is set to fall as the mismatch continues to unwind but, as that process ends and the demographic shock starts to bind, we think inflation is set for a rollercoaster ride. 

More generally, we thought both shocks implied a new macro regime where fundamental limits on production would create a sharper trade-off between growth and inflation and a more volatile economic environment. This continues to be the case. It means this is not a business cycle, so the usual framing around “soft vs hard landings” – inflation coming down without a (major) hit to economic growth – likely does not apply. The economy is not landing. It didn’t take off in the first place. Instead, the economy can no longer grow as much as we’ve been used to in the past without resurgent inflation – and is now flatlining towards that lower level of growth.

Since the pandemic, fiscal policy support – in the form of “stimulus checks” – has helped to sustain overall consumer spending. But more importantly, the pandemic changed the way people spent: more on goods at home, less on services outside. The economy was not set up to meet that shift in spending patterns so supply couldn’t keep up with higher goods demand. That mismatch pushed up goods prices, sparking the biggest bout of inflation in 40 years.

What’s also now become clearer is that the labor market could not quickly match the spending shift, creating a combination of higher job vacancies and wages rising quickly – driving up inflation more broadly.

How did that happen? With the surge in demand for goods, manufacturers needed more workers. The closure of many services meant workers were available, but not with the right skills. That made it difficult for goods-producing companies to fill their vacancies. You can see the effect of that in the Harder to match workers to jobs chart below. Normally, a higher number of unfilled job vacancies is associated with a lower level of unemployment. The relationship is pretty steady and makes sense: when fewer people are unemployed, it’s harder to find people to take jobs. But compared with before the pandemic (orange dots on the chart), we’ve seen a higher level of unfilled job vacancies at any given level of unemployment (green dots). The relationship – which economists call the Beveridge curve – has shifted. In February 2020, right before the pandemic took hold, there was an average of 1.2 unfilled vacancies per unemployed person. In March 2022, there were 2 – the highest ever, largely reflecting the need for firms to find workers quickly amid a rapid restart and difficulty in finding those with the right skills.¹ Even though unemployment was no lower than before the pandemic, companies had to up their pay to lure the workers with the skills they needed – and annual wage growth nearly doubled from 3% pre-pandemic to almost 6% in mid-2022.

The mismatch between spending and supply is now resolving. Consumer spending is normalizing, though it is taking a little longer than we expected. We estimate that about two-thirds of the spending shift has now unwound.² most evident in goods prices, which are now dragging inflation down as demand falls back to normal levels. At the same time, the number of unfilled job vacancies is falling without unemployment rising (yellow dots). Consistent with that, wage pressures have eased from over 6% a year in 2021 to 4% in the second quarter of 2023. That’s helping inflation ease further, too. See the Inflation on the way down chart.

We expect inflation to keep coming down by itself as the mismatch continues to resolve. So far, so good. But…

We think this reassessment of the past two years reveals something not so good: growth has not been as strong as we thought.

We previously thought the aging population was already creating worker shortages and was another driver of the inflation we have seen. A growing share of the U.S. population is past retirement age. And on top of that, a rise in early retirement in the pandemic means the share of those aged over 54 still in jobs or looking for work has shrunk. All told, the workforce is four million smaller than it would have been if it had kept growing evenly across age groups and at its pre-Covid pace. See the pink line on the Meagre job growth post-Covid chart.

That should mean employers face more competition for workers – resulting in pressure to raise wages. Yet the recent easing in wage growth reveals that this is not yet biting. How come?

It can only be explained by weak overall job growth since the pandemic. We’ve seen high monthly numbers of new jobs in the past year, but that largely reflects climbing out of the pandemic employment hole and the almost overnight loss of 15 million jobs. The big down and up in the pandemic and restart masks the broader picture: even as the economy restarted it has only created about half the number of new jobs in the last three years that it had created the three years before. See the yellow line in the chart.

Had the economy added new jobs at the same speed as it was pre-pandemic, the aging workforce would have been a binding constraint, putting persistent pressure on wages, we think. Instead, the aging workforce has so far been able to keep up with the much slower pace of job growth than before the pandemic (the yellow line has not risen above the orange line).

And that in turn tells us that, apart from the initial restart, the economy has experienced very tepid growth over those three years. Modest job growth is consistent with overall economic growth that is much weaker than the GDP data would suggest and more in line with an alternative measure of activity: GDI, or gross domestic income. That measure shows that the economy has grown by just 1.2% a year since the pandemic started and has been standing still for the last 18 months. See the GDI a more reliable measure? chart. It wouldn’t be the first time the two gave a different steer — and GDI emerged as more reliable. A Fed study of GDP and GDI during recessions found that GDI was quicker to pick up the timing and depth of downturns, especially during the global financial crisis.

We don’t think GDI is perfect and recent numbers could be revised up a bit. But we believe the picture painted overall is one of an economy that has not been as resilient as many think and as the GDP data so far suggest.

So, our look-back tells us inflation has so far been more about mismatch than the demographic shock – and growth has been even weaker than we appreciated. What about looking forward? Have a look at part 2 …