By Joseph H. Davis, Ph.D., Vanguard global chief economist

My first childhood memory is of sitting in the back of an estate car with my brother. My mother was at the wheel and we were in a long line waiting for petrol. It might have been 1974; I learned, at some point, that an embargo by oil-producing nations had created shortages that led to even-and-odd-day rationing. The last number on our license plate was 8, so we could buy petrol only on an even-numbered date.

I’ve thought about this recently because shortages of various goods and services, coupled with inflation like we’ve not seen in ages, have some observers wondering: Are we about to revisit the 1970s?

I understand their concerns because rapidly rising inflation eviscerated the economy back then. The unemployment rate rose dramatically and it was a terrible environment for investors for two or three years.

I can tell you that, no, we’re not about to enter a period of stagflation – stagnant economic activity amid high unemployment and inflation – like the 1970s. We continue to anticipate economic growth and, unlike in the 1970s, demand for workers is high. Among several challenges, the most significant factor holding back the economy now is a lack of workers.

The brown bars in the chart below represent economic output lost because of a shortage in the supply of goods – kitchen cabinets or whatever you want to buy. These are losses that have intensified since the pandemic started early in 2020.

If you’re looking to buy a new or used car or trying to complete a home repair, you’ve likely experienced supply shortages firsthand. Or if you’ve been successful in your efforts, you may have paid more than you expected.

How shortages dragging on US growth

Source: Vanguard calculations, using data to 30 September 2021 from the US Bureau of Economic Analysis and the US Bureau of Labor Statistics.

Such supply tightness shouldn’t come as a surprise; for many workers, although their lives were disrupted by the Covid-19 pandemic, their paychecks weren’t. Online demand grew incredibly strong at the same time production was disrupted globally.

Now, though, the shortage of workers, represented by the bluish-green bars in the chart above, is starting to influence our forecasts more significantly. Although we still anticipate significant growth, we’ve lately downgraded growth forecasts for many countries and regions, and it’s not because demand is weak.

Debt crackdown in China adds to growth pressures

At the same time, China is working to mitigate leverage in the financial system, specifically in the property market. China is intentionally and permanently changing its business model, and I think the market underestimates this.

China is no longer focused solely on driving real estate expansion and leverage to become a middle-income economy. When it fixates on a problem, it doesn’t let go, and now China is re-pivoting its growth model again.

Real estate has accounted for roughly 30% of China’s growth. In the United States, it accounted for, at most, from 10% to 15% before the global financial crisis.

Share of household wealth

Source: Vanguard calculations, using data from the People’s Bank of China and the US Federal Reserve to 2019.

So there’s a concerted slowdown in China. Although nothing alarming, in the sense that it will lead to a hard landing, it’s coming at the same time we’re seeing constraints on US and European economies that want to run faster but can’t because of a lack of availability of goods and services.

How will this play out?

So we have growth slowing in the United States and China and we have oil prices shooting higher again. Is it going to be like 1974? The answer is clearly ‘no’.

The one big difference – and it's a material difference – between now and the economic environment in 1974 is that demand for workers now is extremely high, as the chart below shows.

US job openings per unemployed worker at an all-time high

Source: US Bureau of Labor Statistics, accessed 30 August 2021 through the Federal Reserve Bank of St. Louis FRED database.

The reason we have supply and labour shortages is because incomes have been growing, policy support from the US federal government has been as large as it was in World War II, and now we have the economy coming back online.

We've underestimated supply chain disruptions but demand wants to go further still. It’s why we’ll see higher inflation, but not a stagflationary environment.

US labour market red-hot in “non-Covid” sectors

Source: US Bureau of Labor Statistics, accessed 30 August 2021 through the Federal Reserve Bank of St. Louis FRED database.

The chart above breaks down the number of US openings per unemployed worker into three sectors – information technology; financial services; and professional services such as law firms – that were not engaged in the face-to-face activities so disrupted by the pandemic.

So what’s the ratio of job openings to unemployed or marginally employed workers in professional services? Two to one. I added the lighter-shaded bars to show the last time the labour market was ever this tight, and we’ve surpassed that.

There is a genuine significant pressure on demand and we will continue to see it. Among the reasons these conditions have become so acute so quickly is that a number of workers have stopped looking for work. Part of this pressure will be relieved. Wages are starting to go up, which will draw workers back, and this is very positive news given some of the profound shocks that had hit the global economy.

But that introduces different risks to the forecast. The risk in the next six months is growth that’s perhaps a little bit weaker than expected in the United States and some weakness in China with its real estate clampdown.

Still, the ratio of job openings to unemployed shown above aren’t coming down very quickly, which means we have a shift in risk in the next 12 months.

If in the near term there’s a modest downside risk to the markets, if they’re vulnerable to a downside risk to growth, the further-out risk is when the supply chain disruptions start to moderate. When all those cargo containers off the port of Los Angeles can finally be offloaded, we’ll have another issue, because the US Federal Reserve (Fed) will then need to normalise policy.

The chart below reflects Vanguard’s assessment of whether monetary policy is stimulative or tight. The higher the line, the tighter the conditions, which is what you tend to see if inflation is out of control and the labour market is already at full employment. The shaded areas represent recessions.

The Covid-19 recession was deep, but it was so short that it barely registers on the chart. You can see how stimulative the monetary policy was – appropriately so – during the recovery from the global financial crisis.

But monetary policy is more stimulative today than it was during the global financial crisis, and this isn’t a debt-deleveraging recovery. This chart also doesn’t reflect fiscal policy.

Monetary policy remains historically accommodative

Notes: Vanguard’s proprietary monetary policy measurement examines the effect of the policy rate, central bank asset purchases, and inflation relative to the neutral rate of interest to gauge how “tight” or “loose” policy is.

Sources: Vanguard calculations, based on data from the Federal Reserve, the US Bureau of Economic Analysis, Laubach and Williams (2003), and Wu-Xia (2016). Accessed via Moody’s Data Buffet as of 30 September 2021.

Policymakers have been extremely successful in arresting a horrible shock. It’s a reason many companies didn’t go under.

In one sense it was a heroic effort. But the critic in me says, be careful of fighting the last war.

If we wait too long to normalise, we're going to have another issue on our hands: the potential for strong wage growth to fuel more persistent inflation. We considered how transitory recent inflation spikes are in a recent research paper, The Inflation Machine: How It Works and Where It’s Going. If we get past the supply chain issues, which I think we will, the Fed will have to be adept. It should not raise interest rates now in the face of a profound supply shock. But when those conditions are ameliorated, the Fed will need to have the conviction to raise rates in an environment where the inflation rate may be coming down and the labour market continues to tighten.

The time of 0% interest rates should soon come to an end. That will help keep the growing risks of more permanent inflation at bay.


Vanguard Americas chief economist Roger Aliaga-Díaz, Ph.D and the Vanguard global economics team contributed to this commentary.

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