Sticker shock

• Inflation remains hot
• Labor shortage at record level
• Those forces could converge
• Eyes on the Fed this week
• Picture for CRE mixed

Last week two of our most frequently discussed economic phenomena attained heights rarely, if ever, seen. First, inflation data showed prices rising at the fastest level in decades. Second, the number of open jobs reached a new record high. The interconnected nature of these two items warrants discussing them together. And while we expected these outcomes, they still raise the question of whether either of them, or both, represent a problem for the economy.

Inflation still a hot topic

The consumer price index (CPI) for May showed prices rising faster than anticipated. The headline CPI grew at a year-over-year rate of 5%, up from 4.2% in April. That represented the fastest pace since 2008. Meanwhile the core CPI increased at a year-over-year rate of 3.8%, versus 3% in April, the fastest pace since 1992. As we have frequently discussed, we expected inflation to rise to levels unseen in decades. We have detailed the explanation for this previously but in short, demand is currently increasing faster than supply. Why? The short explanation – vaccines arrived faster and proved more successful than many people thought they would. This has enabled consumers to resume spending relatively quickly. But supply, reduced (voluntarily and involuntarily) in anticipation of a severe and likely prolonged downturn in spending, takes time to recover. This timing mismatch is producing this spurt of inflation. But we continue to believe that even after this initial torrent, inflation will settle in at a rate unseen during the last cycle. Why? For a few key reasons. First, some of the more jolting supply issues will take longer to resolve. Second, demand should remain elevated for some time (even though recent spending rates are unsustainable). And third, inflation expectations have recently increased, albeit slightly. The combination of these factors should cause inflation to settle in at levels unseen since before the financial crisis, but likely not at levels damaging to economic growth. The easing of some noteworthy price increases, such as lumber (already easing) and used automobiles (likely ahead) will get somewhat offset by future increases (likely housing as rents look set to escalate).

The Treasury market seems to agree with us. After bottoming out during the initial and most uncertain stages of the pandemic, interest rates started rising as inflation and inflation expectations began to increase. Both accelerated notably early this year. But after peaking in March, the 10-year Treasury yield has fallen back by nearly 30 basis points. Why did this occur despite inflation continuing to rise? Analyzing technical measures like Treasury yields always proves challenging. But yields began falling back as net job creation began to come in below expectations, blunting the most wildly optimistic projections for the recovery and likely leading to more realistic views of where prices could head. 

Help (desperately) wanted

As net job gains began to fall below forecasts, a topic we have discussed frequently and in detail came back with a vengeance: the pronounced labor shortage. We discussed how the labor shortage presented a structural problem without an easy fix and consequently it would get worse over time before alleviating. Even with the massive disruption of the pandemic, that has clearly proven true. As of the end of April, the number of open jobs reached roughly 9.3 million, a new record. And the pace is accelerating: 762,000 in March (the fourth-highest monthly increase) followed by 1 million in April (the highest monthly increase). And the quits rate – the percentage of people quitting their job – also reached a record-high level. Why? Labor demand is outstripping labor supply by a wider margin and increasingly employees recognize this. But there appears to be both a cyclical and structural component to this. The cyclical component looks like what is occurring with inflation: demand is rebounding faster than supply. We expect this component to alleviate over time. But the structural component, driven by demographics, should prove more durable. With baby boomers retiring (a phenomenon accelerated by the pandemic) labor supply growth is slowing. For the first time in U.S. history the growth rate of the working-age population (people aged 16 to 64) has consistently turned negative. 

This presents a slew of issues for the economy but could contribute to higher inflation this cycle. If a labor shortage pushes up wages that could influence inflation expectations. Both have risen recently. Only time will tell, but we see the labor shortage as a factor in our inflation outlook. Yet, we do not hold a dire view of this because of another belief: that investment this cycle will boost productivity growth at the margin. That productivity growth should help hold inflation in check, even though it will likely not completely nullify it. We see this as a bit of a shift in the structure of economic growth in the U.S. For most of the last 40 years, labor has remained relatively abundant due to the baby boomers. But with demographic change, businesses will increasingly have to rely on investments in technology because of labor scarcity. 

The Fed is next in line

The Fed is meeting this week.  While it should not make any policy moves, it will release new forecasts that forecasters will closely analyze. Observers will look for the timing of future rate hikes and any hints at when the tapering of asset purchases could begin. We expect the Fed to reiterate its desire to leave policy intact until the recovery is rooted more firmly, but the amateur linguists should be out in force, dissecting every word and change of wording from the Fed. 

|  What else we are watching this week  |

Advance retail sales for May should show a decline, reinforcing our view that March’s growth rate should represent the high-water mark for this year. We expect to see the composition of sales shifting from goods to services as the economy more fully reopens. The producer price index (PPI) for May should show another noteworthy increased, pushing the year-over-year rate to a record-high level. 

|  What it means for CRE  |

We have consistently stated that commercial real estate (CRE) should capitalize on the upward movement in inflation, via its inflation-hedge. We stand by that view. But another factor should also help the sector. All else equal, higher input prices could limit supply growth, which could also help support the recovery in rents and asset prices. We stress that this could happen because much will depend on the assumptions for rent growth. 

We consistently view the labor shortage as a net negative for economic growth and demand for space of all types. All else equal, vacancy rates would be lower and rents would be higher with greater labor supply. We will update our detailed analysis of this in the future once the rate of change slows a bit. 

|  Thought of the week  |

According to a recent analysis, 68% of companies with the largest CEO compensation packages had wider gaps between executive and employee (ratio of executive to median) compensation after the pandemic.