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Although the U.S. economy has restarted, the labor market recovery has not been smooth. One manifestation is that the unemployment rate and the vacancy rate have both risen, and the friction in the labor market has intensified. At its FOMC meeting in June, the Fed predicted that the unemployment rate would fall from 5.9 percent in June to 4.5 percent at the end of the year and further to 3.8 percent by the end of next year. We think the Fed may have overestimated the rate at which the unemployment rate is falling. The labor market friction caused by the epidemic is unprecedented, the natural unemployment rate may rise compared with before the epidemic, and the unemployment rate may not decline linearly as predicted by the Fed. If the Fed's undervaluation of inflation was the first time it has made a mistake, misjudging the unemployment rate may be another mistake. Maintaining monetary easing to "promote employment" will increase the risk of inflation upside and exacerbate market volatility.
Labor market friction exists at both the industry and regional levels. In terms of industry, workers' work preferences have changed after the outbreak of the epidemic, and they are no longer willing to engage in contact, low-wage service industries. One piece of evidence is that in industries where the proportion of people working from home is lower and wages are lower, the more employee turnover rates rise. Another piece of evidence is that job seekers value flexibility in working hours and location when looking for a job. Workers' reservation wages have also risen significantly after the pandemic, with reserved wages for those with low education rising even more. According to neoclassical economic theory, retaining wage increases will reduce workers' willingness to work, reduce working hours, and exacerbate labor matching contradictions.
The far-reaching impact of the pandemic on work preference has also been confirmed by some psychological studies. The COVID-19 pandemic is a strong event shock that could affect workers much more than the general recession. First, recessions are less novel to workers because they occur at a certain frequency (about every 5-6 years). Covid-19 is an unprecedented and unique event. Second, recessions are gradual, and workers can predict future movements to some extent. The COVID-19 pandemic is sudden, and predicting future trends is nearly impossible. Third, while the recession will affect the physical and mental health of the unemployed, the impact of the pandemic on human health is more immediate and the consequences are more severe. In short, we should not underestimate the far-reaching impact of the pandemic on decision-making on workers' behavior.
Geographically, the rise of telecommuting has changed the pattern of migration and settlement, and the resulting "donut" effect has exacerbated labor mismatch. We found that after the outbreak, people migrated from urban centers with high population density to suburbs with low population density, making urban centers form a "donut" hollow. People who flow to the suburbs (mostly highly skilled white-collar workers) have not left the city completely, but have entered a hybrid mode of "three days at home, two days to clock in". Under this model, the supply of labor in urban centers exceeds demand, and the supply of suburban labor exceeds demand. We believe that until the epidemic is fully controlled, the mixed office model may not disappear anytime soon, and the mismatch between urban and rural areas will continue.
One macro consequence of labor market friction is a rise in the natural rate of unemployment. Rising natural unemployment means a decline in the number of available labour, and in the absence of improvements in production efficiency, the long-term trend growth rate will decline. The implication for asset prices is a downward trend in the neutral real interest rate (r*). But if U.S. fiscal policy can continue to exert its strength and promote labor productivity growth, it will also support r*. Rising natural unemployment also means less room to reduce unemployment by stimulating demand. In our view, if monetary authorities continue to adopt excessively loose demand stimulus, the likelihood of inflation will rise.
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Labor market frictions have intensified
As vaccination progresses, the U.S. economy accelerates its recovery, but the recovery of the labor market is not smooth. From the perspective of employment, the new non-farm jobs in April and May were less than expected, and recovered in June, but there were not many surprises. On the other hand, micro-research reports show that the "labor shortage" faced by American companies is intensifying. Some companies have been forced to scale back or delay expansion due to understaffing, and some of them expect this to continue into the fall (see the report "The Labor Shortage Is On the Rise").
One angle to look at the labor market is to look at the Beveridge curve. Beveridge Curve by British economist Williams. Beveridge proposed to depict the relationship between the unemployment rate and the vacancy rate (hence the UV curve). During the recession phase, employers reduce their demand for labor, vacancy rates fall, and unemployment rises. During the economic recovery phase, employers resumed recruitment, vacancy rates rose and unemployment fell. Thus, the Beveridge curve is a curve with a downward slope that represents a negative relationship between the unemployment rate and the vacancy rate. However, after the outbreak, the unemployment rate and the vacancy rate both rose, and the Beveridge curve as a whole moved outward (Chart 1).
The outward shift of the Beveridge curve is often seen as a manifestation of increased friction in the labor market and increased difficulty in matching. In the labor market, every job has specific attributes – such as wages, working conditions, required skills, and geographic location. Every potential worker also has a set of skills, abilities and work preferences. Employment arises when there is a match between a particular worker and a specific job. However, at any given time, some workers will not have jobs, some jobs will be vacant, workers and jobs will not match, and unemployment will occur. Economists call unemployment that occurs in the process of matching workers with work frictional unemployment. The causes of frictional unemployment often include information asymmetry, high search costs, changes in the structure of the economy, and some institutional barriers. When frictional unemployment occurs, both the unemployment rate and the vacancy rate will rise, and the Beveridge curve will move outward.
Labor matching is difficult, where is the difficulty?
Labor market friction first occurs at the industry level. We found that the job vacancy rate and unemployment rate in almost all industries after the outbreak increased compared with before the epidemic, with the leisure hotel industry rising the most (Chart 2). From May 2019 to May 2021, the unemployment rate in the leisure hospitality industry rose from 5.0% to 10.1%, and the vacancy rate rose from 6.0% to 9.6%. That is to say, after the outbreak of the epidemic, a large number of workers lost their jobs from the leisure hotel industry, but on the other hand, with the economic restart, the recruitment demand of the leisure hotel industry is also the strongest. So the current problem is that these people who are unemployed from the leisure hotel industry cannot or are unwilling to return to work in the industry for some reason, which in turn makes it difficult to match within the industry.
Why are workers "fleeing" the leisure hospitality industry? One explanation is that the leisure hotel industry is a contact service industry, and the higher health risks under the epidemic, coupled with low wage levels, are less attractive to job seekers. We found that the quit rate of the NON-farm sector in the United States increased significantly after the outbreak of the epidemic. By industry, industries with low levels of work from home have a greater increase in turnover rates than before the pandemic (Chart 3). At the same time, industries with low average wages have seen a greater increase in turnover rates (Chart 4). This shows that during the epidemic, not being able to work from home and paying too low will prompt workers to voluntarily resign. Not only is it difficult to work from home, the leisure hospitality industry also earns an average of just $17 an hour, the lowest of any major industry. It is not difficult to understand why workers are reluctant to work in the leisure hotel industry.
The pandemic may have changed people's work preferences, and future job seekers will pay more attention to the flexibility of working hours and locations. According to Joblist's survey, in the second quarter of 2021, when asked why they were reluctant to choose a job in the leisure hospitality industry, 58% of job seekers said they "wanted to work in a different environment", saying that the proportion of "inflexible working hours" and "wanting to work from home" reached 16% and 14% respectively (Chart 5A). When asked what factors have prompted job seekers to return to the leisure hospitality industry, a whopping 69% of respondents said that "no change will bring me back", indicating that they are more determined to leave the leisure hospitality industry (Chart 5B). In addition, when asked which benefits are more important when looking for a job, 68% of people choose health care, 60% choose flexible working hours, and 34% of those choose to work from home (Chart 5C). This suggests that people prefer to work in more flexible working hours and locations.
These changes can be explained by the labor supply theory of neoclassical economics. According to neoclassical economics, workers optimally allocate limited resources between consumption and leisure in order to maximize utility (Figure 6). An important factor in determining distribution is income, which in turn is divided into labor income (wages) and non-labor income. Under normal circumstances, the rise in non-labor income will have an income effect, and workers will increase consumption and leisure at the same time, reducing the supply of labor. Rising wages will have two opposite effects: one is the income effect, which is also a result of reducing the supply of labor; the other is the substitution effect, higher wages increase the marginal return on work, prompting workers to reduce leisure and increase labor supply. After the outbreak, the U.S. government issued a large number of cash and unemployment subsidies, bringing a strong income effect. According to the theory of neoclassical economics, if workers increase consumption and leisure at the same time, and reduce working hours, the supply of labor will decline. This also explains why the US labor force participation rate has fallen sharply after the outbreak.
We also found that workers' reservation wages also rose significantly after the pandemic [1]. This will reduce the willingness of workers to work and reduce working hours. According to the neoclassical theoretical framework, retention of wages is a key factor in determining the supply of labor, and workers are only willing to enter the labor market when market wages are higher than reserved wages. According to the New York Fed, in March 2021, the average retained wage for workers rose to $71,000 from $62,000 a year ago, an increase of 15% (Chart 7). Among them, the reserved salary of those with a college degree rose from $49,000 to $61,000, an increase of 24%. This may mean that workers with low education are more reluctant to work. This also partly explains why labor shortages are worse in low-wage-earning industries, where wage levels rise faster after the economy restarts [2] (Chart 8).
In addition, the impact of the epidemic on work preference has also been confirmed by some psychological research institutes. Research by McFarland (2020) and others shows that the pandemic is an unusual and eventful shock for workers, triggering a rethinking of employment intentions and career paths. The authors found that after the outbreak began, the number of job applications from workers increased immediately due to concerns about uncertainty about the future. In the job search category, the proportion of jobs that can work from home is significantly greater than that of face-to-face jobs, reflecting workers' aversion to and aversion to the health risks posed by the pandemic.
The impact of the pandemic on workers' behaviour is likely to be much higher than that of the general recession, as the pandemic is extremely unique, destructive, and unpredictable. Based on the theory of event systems, any macro event will affect the behavior of workers. For example, after a recession, the mental burden of the unemployed increases due to excessive anxiety, and even leads to an increase in suicide and crime rates. The difference between COVID-19 and COVID-19 is that the impact is much stronger than the average recession. First, recessions are less novel to workers because they occur at a certain frequency (about every 5-6 years). The COVID-19 pandemic is an unprecedented and unexpected event, with the last time a similar global epidemic occurred was due to the Spanish flu in 1918. Second, recessions are gradual, and when economic data begins to weaken, workers can predict future movements to some extent. Covid-19 is sudden, and predicting future trends is nearly impossible. Third, while the recession affects the physical and mental health of the unemployed, the impact of the pandemic on human health is more direct – it directly leads to illness, hospitalization, and even death of infected people.
All in all, the pandemic is a particularly strong macro event, and we cannot underestimate its far-reaching impact on decision-making on workers' behavior. As of the end of July 2021, the COVID-19 pandemic had killed 620,000 Americans, a figure that was second only to the Spanish flu and the American Civil War, arguably the third most life-threatening event in U.S. history (Exhibit 9). Until now, the epidemic in the United States has not ended, and the number of new confirmed cases is still increasing (Chart 10).
The "donut" effect exacerbates friction
From a geographical perspective, the rise of remote work will change the migration and settlement patterns, which will affect economic activities and labor supply and demand in different regions, and increase labor market friction. Working from home has become the new normal for many contactless industry positions, with remote work allowing people to live farther away from the company, reducing commuting and face-to-face contact.
Specifically, the epidemic has a "donut" effect on population and company migration patterns, that is, the migration from high-density urban center areas to low-population density periphery, making large urban centers form a "donut"-like void. The contact transmission nature of the epidemic has pushed up the risk of infection in urban centers where people are concentrated, and remote work has reduced the necessity and cost performance of living in the city, and the two factors have superimposed, resulting in a significant increase in the overall net outflow of US cities after the outbreak (Chart 11).
Interestingly, this migration is not from the metropolis to the distant countryside, but to the suburbs around the metropolis. Chart 12 shows the cumulative net inflow/outflow of people in the New York area and the San Francisco Bay Area from February 2020 to February 2021, with net outflows in the red areas and net inflows in the green areas, which can be clearly seen as the population migrating from the center of the city to the suburbs. Data on the real estate market and data on business registrations also confirm the willingness of this population to migrate to the suburbs. Studies have shown that in low-population density suburbs, rents, house prices, and the number of net business registrations are on the rise.
Why do "donuts" occur within cities, not between cities? One reason is that people don't leave the metropolis entirely. For example, many companies implemented a hybrid system after the outbreak of the epidemic, that is, only go to the office 1-2 days a week, and work from home for the rest of the time. This limits the distance between the population and the movement of the population to a certain extent, and workers cannot be too far away from their offices. Another study found that the larger the scale and the higher the population density, the more obvious the "donut" effect. This is because large cities tend to have more highly skilled employees, such as technology and finance, who work remotely at a higher rate, have a stronger ability to migrate[3], and are also wealthier and able to afford to buy homes in the suburbs.
The "donut" effect has led to a mismatch between labor supply and demand between cities and suburbs. Figure 13 shows the principle of urban-rural mismatch. Before the epidemic, most of the labor demand was concentrated in cities, and the supply of labor in cities was also more, and labor supply and demand were in a state of matching. After the outbreak of the epidemic, many high-skilled workers flowed into the suburbs and adopted a mixed office model of "three days at home, two days to punch in", which diluted the demand in urban centers on the one hand and boosted the demand in the suburbs on the other hand. But on the supply side, high fixed costs such as opening stores and relocating limit the elasticity of supply, and it is difficult for companies to respond flexibly between cities and suburbs, and their employees (mostly low-skilled) have no way to move back and forth between cities and suburbs like white-collar workers. As a result, there is an oversupply of urban labor and an undersupply of suburban labor. A typical example is Starbucks, where white-collar workers who work from home can't buy Starbucks in the suburbs, and Starbucks near office buildings in the city center is uninhabited.
We expect the urban-rural mismatch to continue for some time, which will drive up supply costs and increase inflationary pressures. As can be seen from the above cases, the total demand before and after the epidemic has not changed, but the redistribution of economic activities between regions has reduced the demand density of both cities and suburbs. This "anti-scale effect" will reduce the ability of enterprises to acquire customers, push up the marginal cost of operations, and may eventually increase inflationary pressures. Looking ahead, it is uncertain whether and when demand will return to the big cities until the outbreak is fully under control. Low-skilled workers who were originally engaged in contact industries in big cities, if they also moved to the suburbs like white-collar workers, may face the dilemma of falling suburban demand and losing their jobs again after the epidemic improves. As a result, many idle laborers may prefer to stay in the city and wait for opportunities rather than drag their families and embrace risk. It also means that geographical mismatches and frictions can last longer than expected.
The meaning of rising natural unemployment
One macro consequence of labor market friction is that the natural rate of unemployment will rise. Natural unemployment describes unemployment due to variables other than cyclical factors, which are usually related to changes in the structure of the economy (such as demographic structure, technological progress), and natural unemployment is therefore called non-cyclical unemployment. In general, the natural unemployment rate is relatively stable in the short term, but if the labor market friction intensifies, it will also increase the natural unemployment rate in the short term. One example is the bursting of the housing bubble and the outbreak of the financial crisis in 2008-12, which combined with the intervention of government subsidies, increased labor market friction[4] and pushed up the natural unemployment rate (Chart 14). As mentioned earlier, the impact of the COVID-19 pandemic on the labour market is likely to be greater than the subprime mortgage crisis of 2008. Therefore, we have reason to believe that this time the natural unemployment rate will also rise.
What does rising natural unemployment mean for macroeconomics and asset prices? First, rising natural unemployment means a decline in the number of available labour, and in the absence of improvements in productivity, the long-term trend growth rate will decline. The implication for asset prices is a downward trend in the neutral real interest rate (r*). In fact, the impact of the impact of the epidemic on r* is controversial, and optimists believe that the epidemic will accelerate the development of the digital economy and help improve the overall efficiency of society in the long run. Pessimists believe that the scarring effect of the epidemic will make it difficult for the economy to return to pre-epidemic levels soon, such as some service production activities will disappear in the long run, and the potential growth rate of the economy will be dragged down.
In our view, the intensification of labour market frictions after the outbreak, coupled with various supply bottlenecks, may suppress r* for a period of time, which in turn will suppress real interest rates reflected by asset prices (Chart 15). But on the other hand, if the US fiscal stimulus policy continues and the gap between rich and poor improves, it will also support R*. From the perspective of the capital markets, if investors expect that real interest rates will not rise quickly in the short term, the speed and magnitude of the rise in US Treasury yields will also be dragged down. Since the beginning of the year, the real interest rate on the 10-year Treasury has remained largely unavoidable, while inflation expectations have risen more (Chart 16).
Second, rising natural unemployment means less room to reduce unemployment by stimulating demand. If policymakers maintain excessively loose demand stimulus, the likelihood of triggering inflation will rise. Most of the causes of natural unemployment are non-cyclical, and it is difficult for monetary authorities to reduce natural unemployment through counter-cyclical monetary easing. Instead, the continued sharp easing of monetary policy may push the real unemployment rate below the natural unemployment rate, bringing additional inflationary pressures.
As of June 2021, the unemployment rate announced by the US Department of Labor (BLS) has fallen to about 6%, and assuming that the natural unemployment rate rises from 4.5% before the epidemic to 5.5%-6% after the epidemic (which is also the high point of the natural unemployment rate after the subprime mortgage crisis), there is not much room for monetary policy stimulus. From this perspective, the Fed may need to find a new balance between boosting employment and preventing inflation. Looking ahead, if inflation expectations rise further next, it is not excluded that the Fed will be forced to withdraw from easing early (Chart 17). This is also the risk that the capital market needs to pay attention to in the second half of the year.
[1] The reserved wage is the minimum wage acceptable to workers working in the market. If the type of work and working environment are the same, the employee will refuse a job offer below this level. Through the SCE Labor Market Survey, new York Reserve obtained the average minimum wage that respondents were willing to accept for a new job, which reflected the level of retention wages.
[2] High-wage-earning industries include information, utilities, finance, professional and business services, and mining; middle-wage-earning industries include wholesale, construction, manufacturing, education, and health services, and other services; and low-wage-earning industries include transportation, warehousing, retail, and leisure hotels.
[3] 参见Althoff， Eckert， Ganapati and Walsh （2020）
[4] Friction at that time occurred mainly in the construction industry. Many construction workers have lost their jobs due to the bursting of the housing bubble, and because of their low skill levels, it is difficult to find new jobs in the short term, which in turn exacerbates labor market frictions.
Article source
This report is excerpted from: The Overseas Macro Special Report "After Underestimating Inflation, the Fed May Make Mistakes Again" released on July 27, 2021
This article originated from the Financial Circle Network