Stagflation Could Turn From A Temporary To A Permanent Problem

Stagflation, an economic situation of slow growth and elevated inflation, has hit the U.S. in the last year due to rising food and energy prices and may take on more permanence for the economy for several reasons.

First is the secular decline in the U.S. labor force due to the aging of the population, lower labor force participation, and tighter immigration.

For instance, the civilian labor force growth has dropped from roughly 50% in 1960-1980 to 38% in 1980-2020 and 12% in 2000-2020. Meanwhile, labor force participation dropped from a peak of 67% in the late 1990s to a low of 62% in the early 2020s. Moreover, net immigration, which exceeded one million in 2016, has been dropping yearly, reaching 569,000 in 2019 and 477,000 in 2020.

Second is a secular decline in capacity utilization, a measure of how busy the nation’s factories are. It dropped from the high 80s in the 1960s to the low 80s in the 1990s. And it has remained in the high 70s in the last two decades.

The third is a recent decline in labor productivity growth, the highest since 1947.

All three trends point to a slowdown in the nation’s production potential, which translates to slower growth. Statista estimates GDP growth will stay below 2% for the next five years — well below the 3% trend the country experienced in the last 60 years.

Worse, slow economic growth may not be sufficient to accommodate the rising demand. As a result, the U.S. economy may be in for prolonged stagflation, even if food and energy price hikes subside.

Paul Kutasovic, a professor of finance at the New York Institute, is cautious about reaching definite conclusions about the direction of the economy for several reasons.

One of them is that unemployment remains low, which will stay low for several years, due to the tight labor market. Thus, “stagflation” shouldn’t be used in the term’s conventional meaning, which includes elevated unemployment. And two, labor productivity statistics may still be distorted by the pandemic. Instead, he’s pointing to multifactor productivity, which has been growing at a healthy rate. Thus, economic stagnation may not be as bad as the labor productivity numbers suggest.

Nonetheless, Kutasovic sees that the tight labor market will continue to put upward pressure on labor pay, meaning that labor will increase its share of the national income at the expense of corporate profits. And that’s a negative development for U.S. stocks in the future.

In addition, he thinks that higher labor compensation could elevate inflation and interest rates, another negative for equities.

Does it mean that equities are in for an extended bear market?

Kutasovic doesn’t think so. But he sees leaner times ahead for investments in U.S. equities.

“The bottom line is that stagflation, in whatever way is defined, may not push U.S. equities into a bear market,” Kutasovic said. “But it will lead to moderate gains.”