The COVID pandemic business cycle was unprecedented across multiple dimensions: A major public health threat on a scale not seen for a century; complex demand and supply shocks; the Ukraine war, and structural shifts in the employment markets.
Remarkably, the U.S. economy rebounded with vigor, supported not only by monetary and fiscal policies, but also a broad range of innovations, including large-scale temporary furloughs, voluntary “work-from-home” arrangements and a coronavirus vaccine.
Yet after demonstrating on-the-fly innovations, productivity and growth, the U.S. is at a crucial turning point where the Federal Reserve’s monetary policy could impair key drivers of the supply side of the economy and snatch defeat from the jaws of victory.
The pandemic economic gears did not mesh perfectly. Supply chain pressures increased significantly in several rounds and peaked at the frontiers of abnormality in December 2021: a negative “Black Swan” event.
Amazingly, these pressures reversed and re-normalized between February 2023 and September 2023. Intermediate processed goods prices also saw acute upward pressure not seen for decades beginning in January 2021, continuing through 2022, as the Ukraine war reverberated through commodity markets. But these pressures also re-normalized in the second- and third quarters of 2023.
The unequivocal good news is that the bulk of these shocks are now behind us, but certain myths and fallacies need to be addressed to get clear on the future potential of the U.S. economy.
Wage inflation is a myth
The popular “wage inflation” mantra is a myth. The share of wage compensation in overall business income declined to 56% in 2019 from 66% in 1960, and during the pandemic cycle the share declined further to 55%. If there were true “wage inflation” the exact opposite would have happened.
Business prices “per unit of output” jumped by an average annual rate of just under 6% during the pressurized period from the end of 2019 to the middle of 2022. Profit per unit accounted for the largest share, about 47% of the price increase. Employment costs accounted for about 40% of the price increase, and other costs 13%. The average annual increase in employment costs during this period was just over 4%, compared to the increase in profits of 22%.
Employment costs were temporarily boosted to a higher level by the recall to work of relatively low-wage leisure and hospitality, and retail trade employees. This reflected a significant increase in the risk and complexity of these occupations. Personal risk, including risk of serious personal injury, infection, illness or even mortality, is a key compensation variable, albeit hard to calibrate, that is consistently left out of employment studies.
By contrast, there was a decrease in relative risk of “work from home” advantaged occupations such as financial services, and information. Nevertheless, average weekly earnings in financial activities and information increased at solid rates.
Business “markups” saw a quantum leap during pandemic cycle. With outsized gains in profit margins, cash held by businesses jumped from $3.70 trillion, or 16.9% of nominal GDP at the end of 2019 to a stunning level of $5.52 trillion, or 20.4% of GDP at the end of the second quarter of 2023. Most of this cash is held by the largest corporations, not by small businesses.
“Real wages rose by just 3% cumulatively over the entire 15-quarter pandemic cycle. Worker productivity, by contrast, rose by 6%. ”
Despite the low unemployment rate, real wages rose by just 3% cumulatively over the entire 15-quarter pandemic cycle. Worker productivity, by contrast, rose by 6%. This contributed to keeping the inflation rate lower than what it would have been otherwise. Real compensation has trailed behind productivity.
Business productivity saw significant gains in the first year and a half of the recovery, then stalled and fell backwards when the economy slowed to a crawl in the first half of 2022. Productivity rebounded for modest gains over the next three quarters, but then accelerated sharply in the second and third quarters of 2023, leading to subdued employment cost gains in the business sector on average of just 1.2%.
Core inflation including rural areas, but excluding shelter, was running at an annual rate near 2% in September 2023. The problematic yearly gains in shelter costs near 7% currently are primarily related to higher metro area population concentrations. But as commercial real estate mortgages roll over into much higher interest rates in 2024, this will put perverse upward pressure on shelter costs, mirroring the real estate environment in 2005-2006.
The massive flip in stance of monetary policy since March 2022 constitutes a significant “unexpected negative monetary shock”, relative to the Federal Reserve’s own forward guidance in March 2022, when the median projection for the midpoint of the federal funds rate at the end of 2023 and 2024 was 2.8%. The range for the fed funds rate is now roughly double that level, at 5.25% – 5.50%.
Moreover the fallacy that productivity-enabled growth in recent quarters is “bad”, therefore requiring either higher rates, or persistently high rates, doubles down on the negative monetary shock and has led to an unanticipated steepening of the yield curve in recent months.
“ Forcing the economy into a slower growth trajectory will lead to a reversal of recent productivity gains, higher employment costs and core inflation persistence.”
A key threshold for productivity gains during periods when the economy is growing is growth near 2% – 2 ¼%. Forcing the economy into a slower growth trajectory will lead to a reversal of recent productivity gains, higher employment costs and core inflation persistence, with little impact on the unemployment rate. It does not make sense to throw out the productivity baby with the shelter-cost bathwater.
In one giant leap of encouraging insight, these positive pandemic developments on productivity and employment costs were acknowledged during Fed Chairman Jerome Powell’s press conference on November 1.
The longer view
The U.S. faces three other major unintended consequences of negative monetary shocks:
First, increased concentration of industry as the strong and dominant get stronger. While the short-term cleansing effects may have some positives, this has to be weighed against long-term higher concentration. Large-scale mergers seldom generate the necessary synergy to justify the premium paid at acquisition. High levels of concentration contributed to the jump in profit margins and the building up of massive cash on corporate balance sheets during the pandemic cycle. Substantially higher concentration, beyond a critical threshold, retards innovation and productivity over the long run.
Second, we are seeing sharp reductions in the flow of risk capital into private equity, venture capital and IPOs. Proceeds from IPOs dropped to an annual average of just $13 billion in 2022-2023, the lowest level in decades. Venture capital investments dropped to $126 billion in the first three quarters of 2023, down from $245 billion in 2022, and venture capital raised collapsed to $43 billion, down from $173 billion.
These trends will have a negative impact on innovation and productivity. Similar sharp declines in the frequency of IPOs and the flow of risk capital occurred after the collapse of tech stocks in 2000-2002, as well as in the recessions in 2001 and 2008-2009. These negative shocks contributed to a major step down in U.S. productivity growth from 2005 to 2019.
Third, the persistence of restrictive monetary policy also will retard the conversion to more costly renewable primary energy and electric vehicle and related battery development and production. We are still a long way from achieving major economies of scale in these new products. The rate of reduction of carbon emissions will be impaired.
It is time for monetary policy to move beyond reductionist short-term models, where the presumed relationships among inflation, unemployment and vacancies are not known with any precision.
Rather, a medium-term view of the path for monetary and financial conditions is needed. This would limit the frequency, size and duration of negative monetary shocks and support a high rate of breakthrough innovations. That in turn would be followed by rapid adoption and commercialization, leading to long term productivity and efficiency improvements. The U.S. then would be adhering to a preferred, pro-growth, pro-innovation framework that would improve both the U.S. economy and the environment.
Brian Bethune is an economics professor at Boston College.
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