Economic Forecast: Slow Job Growth and Inflation

With regard to the economic outlook, President Obama is faced with at least two factors that are beyond his control. One is that the economic cycle appears to have become longer and more difficult to manage. The other is that the news cycle has gotten shorter.

The short news cycle means that pundits are already speaking of this as the Obama economy, even though it is too early for any of his policies to have an effect. The economy does not know that the administration changed in January. Like a large ship, the economy takes a long time to turn.

If anything, the economy has become slower to turn over the last two decades. The period from 2001 through 2003 was notable as a “jobless recovery,” in which businesses were slow to add workers, even though demand was picking up. That was in the context of a relatively shallow recession. (See this analysis of the Dotcom recession.) The current recession is much worse, and if there is a similar lag in boosting employment, we may not see the unemployment rate fall back below six percent for five years or more.

Why has the employment cycle become longer and more difficult to manage? I believe that an important factor is the change in the nature of the American work force, as documented in The Race Between Education and Technology by Claudia Goldin and Lawrence Katz. As recently as forty years ago,  two-thirds of American workers had no more than a high school education. The most significant source of unemployment was temporary layoffs of low-skilled workers from manufacturing firms.

Today, over two-thirds of the labor force has at least some college education. Job losses tend to be permanent, not temporary, and matching workers to jobs is much harder given the diversity of skills. Workers need to find new firms, new industries, and sometimes new occupations. The government does not have any special insight about how to redeploy the work force. You cannot re-employ investment bankers as road builders.

Traditionally, fiscal stimulus would increase the demand for automobiles and for other consumer durable goods. Growth in these sectors would then spill over into the rest of the economy. Today, however, many of the automobiles, televisions, and other durable goods that Americans buy are manufactured abroad.  Much of the low-skilled labor that meets American demand for these goods works overseas. Thus, the ability to increase employment in this country by stimulating demand for consumer durables is not what it used to be.

Another reason to expect employment gains to be sluggish is that most of the fiscal stimulus does not kick in for another year or more. In fact, if the economic recovery begins this year, we will have the irony of a recovery that largely precedes the stimulus, rather than the other way around.

Even though employment growth will be sluggish, we could see an upturn in inflation somewhat earlier than in past recoveries.  There are several reasons for this.

First, the dollar is vulnerable to a decline. Foreign investors may be saturated with U.S. assets, and as they become less willing to absorb American securities our currency may decline. This would boost the prices of goods that come from overseas.

Second, the heavy reliance on government stimulus means less use of the natural forces of supply and demand to guide economic activity. Government might raise demand for workers where it already is strong (in health care, for example) rather than where it is weak. This could put upward pressure on wages and prices in high-demand sectors even though there is continued high unemployment in low-demand sectors.

Third, we will be in a situation in which the Federal Reserve faces considerable pressure to provide excessive monetary growth.  In retrospect, the Fed policies from 2001-2003 are viewed by many economists as too expansionary, helping to ignite the housing bubble. However, at the time, a number of economists, citing the “jobless recovery,” argued that Fed policy was too tight (see the citations of Brad DeLong and Paul Krugman in this article written in 2002.). If we go into an election year with an unemployment rate of 7.5 percent or higher, it is safe to say that the politicians will not support any Fed tightening, even if inflation has begun heating up.

I expect that growth in real GDP will pick up strongly over the next year, as pent-up demand for new household formation and durable goods purchases produces a strong rebound. However, for reasons given above, employment growth will be sluggish while inflation pressures will slowly build. Thus, the scenario might be as follows: In 2010, unemployment averages 8.25 to 8.75 percent, with inflation between 1.0 and 2.0 percent; in 2011, unemployment averages 7.5 to 8.0 percent, with inflation between 2.0 and 3.0 percent.  In 2012, unemployment averages 6.5 to 7.5 percent, with inflation between 3.0 and 4.5 percent. Those numbers will probably be good enough to enable President Obama to get re-elected, but his second term will be plagued by rising inflation, high interest rates, and unsustainable deficits, along with stubbornly high unemployment.