The Big Mistake the Fed Is About to Make

Economists are dramatically underestimating the inflationary pressures that are building in the U.S., a mistake that quantitative manager QMA believes will result in disruptions to financial markets as early as next year.

“The headline unemployment rate is close to the real picture,” said Ed Keon, chief investment strategist at QMA, which is part of Prudential Financial’s asset management arm PGIM. “We’ve looked more deeply at the folks that are unemployed and a relatively small number of them will re-enter the labor force in the foreseeable future.”

For years, wages have failed to go up even as the unemployment rate has fallen and the labor force has tightened. Economists have explained it away as the result of a job market that is more competitive than it appears, a conclusion based on unemployment statistics.

“They argue that even though unemployment is near all-time lows, a large number of people who are not part of the labor force might consider entering, and their presence is enough to keep inflation low for the foreseeable future,” stated QMA in a soon-to-be-released report, “Help Wanted: Why Inflation Might Actually Be Right This Time.” But this so-called shadow pool of unemployed workers fighting for jobs is much smaller than economists believe, Keon said.

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According to the latest data from the Bureau of Labor Statistics, the shadow pool amounts to only 1.5 million people – a fraction of the more than 160 million who make up the known workforce. While it is true that labor participation has declined since 2000, QMA said this is because of aging Baby Boomers, not the “myth” of shadow labor.

“Over 94 percent of those outside the labor force do not want a job, primarily because they have retired, or, to a lesser extent, because they are raising a child or are in school,” the report concluded. “Even of those who say they want a job, half say they are not available to work now.”

Instead of the average 4.5 percent long-run unemployment rate forecasted by the Federal Reserve, QMA said unemployment could fall to 3 percent by the end of 2019. This in turn could result in rising wages that compress the “historically high profit margins that have recently provided support to valuations,” the report stated. “The Fed might have to choose between letting wages and inflation run a bit hot, risking rising inflation expectations, or tightening monetary policy more rapidly than planned, potentially causing a recession.”

QMA suggested that today’s environment may even be similar to the 1960s, when a labor shortfall – alongside factors like increased spending on the Vietnam war and the great society programs – sparked a “rapid increase in inflationary pressures.”

Keon predicted that the labor market may grow as tight in 2019 as it was in the late 1960s, before the inflationary spiral that marked the entirety of the next decade.

“This raises the risk that the U.S. Federal Reserve will either be too complacent (allowing inflation expectations to rise) or too aggressive (causing a recession),” the report warned. “In either case, it could cause significant disruptions in financial markets.”