By David Skilling*

“If the only tool you have is a hammer, it’s tempting to treat everything as if it were a nail,” Abraham Maslow.

The United States reported inflation of 9.1% this week, the highest since 1981, with the Fed now scrambling to react: markets expect a rate hike of 75 basis points or more later this month- this. Soaring inflation and tighter monetary policy are common in advanced economies and beyond.

This is partly a story of excess demand, due to the strong economic recovery from Covid – supported by aggressive monetary and fiscal stimulus. And rising energy and food prices have made a substantial contribution of late.

More broadly, Covid has had a hugely disruptive effect on the functioning of advanced economies: global supply chain frictions, shifts in business models, labor market dislocations, and more. Combined with the strong recovery, these supply-side constraints have generated inflationary pressures.

Indeed, inflation is above all linked to structural dynamics. Factors such as globalization, demographics and technology have exerted significant downward pressure on inflation over the past few decades. The Great Moderation is not only due to the actions of central banks. And monetary policy alone cannot address some of the structural drivers of inflation that are currently at work.

All advanced economies have inflation well above target levels. But there is a change in underlying inflation, excluding the contribution of food and energy prices. At the top are the United States and the United Kingdom, as well as New Zealand. Many European economies have lower core inflation.

This partly depends on the strength of the recovery and the magnitude of the stimulus. But it strikes me that economies that have high core inflation tend to have particularly acute labor market problems.

Where have the workers gone?

Labor market performance in advanced economies during the pandemic has been strong, with unemployment rates not rising (outside the US) – largely due to aggressive policy measures. And unemployment rates are now at relatively low levels, generally below levels immediately pre-Covid.

But there are significant variations across advanced economies in terms of underlying labor market tightness. For example, employment levels in Europe are well above pre-Covid levels, while the US has only just regained those levels – and the UK still has significantly lower levels of employment. This limited labor supply reflects the reduction in participation rates in the United States and the United Kingdom compared to Europe: the shares of the population in the labor markets in the United States and the United Kingdom UK have declined during the pandemic.

The Big Quit was real, at least in some economies, with people leaving the workforce: early retirement, illness/child care reasons, changes in work/life preferences, etc. Also note that policy approaches that kept people tethered to the workforce during the pandemic have been more successful than in the United States, where layoffs were higher.

Another factor contributing to the tightening of labor markets is the reduction in migration flows. Australia and New Zealand, for example, have maintained high participation rates and low unemployment rates during the pandemic. But net migration flows, which accounted for significant shares of working-age population growth in these countries, fell to zero during Covid. For this reason, labor supply growth in these economies is much lower than pre-Covid rates, leading to labor shortages.

This is also the case in the UK, where Brexit has helped limit job growth and labor shortages. And in the United States, the share of migrants in the labor force has fallen thanks to Covid.

These labor shortages have created supply-side constraints at the same time that demand is booming, limiting production and creating price pressures. Economies that have flexible labor markets with support for workers to remain in the labor market have been more successful in avoiding some of these supply-side constraints.

Labor markets disrupted

At the micro level, there has been significant job turnover during the pandemic. Workers voted with their feet, quitting for jobs with better pay and conditions.

Moreover, the location and nature of jobs have also changed through the pandemic: there are new areas of labor demand (from logistics to digital) and some sectors with reduced demand (physical retail) . This will require a large-scale reallocation of labor across the economy, as labor supply and demand are aligned across sectors.

This process will inevitably involve costs and friction as individuals and businesses seek out each other. One measure of the effectiveness of the job search process is the “Beveridge curve,” which maps the number of job openings against the unemployment rate. In many advanced economies, this curve has shifted markedly (more vacancies for every unemployed person), suggesting structural changes in labor markets. In the United States, the ratio currently stands at around 2 job vacancies for every unemployed person.

Economies that invest heavily in skills, have an active and flexible labor market policy and where companies are directly involved in the skills development process (such as apprenticeships, vocational training) should have an advantage in this environment . Small advanced economies, many of which exhibit these characteristics, are able to productively employ a relatively large share of their population.

Demand versus supply policy

The scale of the Covid economic shock inevitably meant that the recovery process would be bumpy. Labor markets are a key area where this plays out, with implications for inflation.

Wage growth remains negative in real terms in advanced economies, with overall wage growth not (yet) keeping pace with inflation. But tight labor markets also affect product markets, creating product shortages and disrupting supply chains, resulting in cost and price pressures. And frictions between labor supply and demand also impose additional costs on businesses.

Economies that have been able to sustain growth in labor supply and help workers efficiently access new jobs will have greater potential output, which will weaken inflationary pressures due to mismatch between supply and demand. The Nordic countries, the Netherlands and Switzerland are good examples.

Tighter monetary policy is needed to reduce excess demand. But pulling demand down to meet weaker supply can be counterproductive. Measures to remove supply from the economy are an important part of the response to inflation. And the key to this will be to ensure that labor markets work well: skills and training, flexibility, support conditions (childcare, minimum wage, etc.).

Some economies, like Singapore, are actively engaged in upgrading skills for the new demands of the post-Covid economy. But these supply-side policy efforts should be more widespread.

Looking forward

Favorable demographics, strong migration flows, the introduction of flexible labor markets, as well as competition from imports, have combined to support labor supply growth and dampen wage growth over the of the last decades. The famous Philips curve has disappeared.

But beyond the immediate post-Covid tensions, structural changes in the global economy are driving changes in this context.

Population aging in advanced economies and beyond (notably in China), together with the likely decline in migration levels in some advanced economies, means that labor supply growth is likely to be structurally weaker. This will create wage and price pressures that cannot be easily contained by tighter monetary policy. Milton Friedman wasn’t quite right.

“Inflation is always and everywhere a monetary phenomenon”, Milton Friedman.

Governments will need to find supply-side measures to address these pressures, through labor market and skills policy, as well as by encouraging the adoption of productivity-enhancing technologies such as automating. The hammer on the demand side of monetary policy cannot be the only solution.


*David Skilling (@dskilling) is a director of an economic consulting firm Landing Strategy Group. The original is here. You can subscribe to receive notes from David Skilling by email here.