Is the U.S. economy headed for stagflation?

The U.S. Bureau of Labor Statistics (BLS) recently announced that employers in the United States added only 38,000 jobs in May 2016. This was the smallest increase in employment since September 2010. Economists had expected about 155,000 jobs to be added in May. The BLS also revised downward its estimates of net total job gains over the first three months of 2016 to an average of 116,000—well below the 200,000 level (on a monthly basis) over much of the previous five years. At the same time, the U.S. unemployment rate last month declined to 4.7 per cent, which was the lowest rate since November 2007 and down from five per cent in March and April.

The weak job-creation report combined with the decline in the unemployment rate reflects a shrinking U.S. labour force. Indeed, the labour force participation rate in the U.S., a measure of the percentage of the working age population currently working or looking for work, decreased to 62.6 per cent in May from 62.8 per cent in April. The labour force participation rate has declined fairly steadily after reaching its peak value of 67.3 per cent in January 2000.

A declining labour force participation rate implies that increases in the demand for workers will result in upward pressure on wages and higher inflation, other things constant. In fact, average hourly earnings over the past 12 months increased by around 2.5 per cent, which exceeded the growth rate of the U.S. economy over that period. The fact that the number of unfilled jobs has actually increased suggests that the decline in the labour force participation rate primarily reflects shifts in the supply of labour, although less than robust growth in demand for labour may be discouraging some from entering the labour force.

With relatively low unemployment and declining labour force participation, it will be difficult to increase real economic growth in the U.S. without the benefit of a significant increase in the growth rate of productivity. Unfortunately, recent productivity growth in the U.S. has been dismal and low rates of capital investment augur poorly for a resumption of faster growth. Furthermore, the aging of the labour force and a (possibly) growing mismatch between the skills demanded by employers and the skills possessed by those without current employment suggest that the labour force participation rate may continue to decline, even with an increase in average wage rates.

The overall economic outlook for the U.S. economy is therefore not encouraging. In particular, supply-side conditions are not supportive of strong real economic growth. As such, a continuation of the Federal Reserve’s relatively expansionary monetary policy will sooner or later contribute to growing inflationary pressures in the United States.

Fortunately, Canada enjoys a somewhat more favourable supply-side picture. Specifically, Canada’s labour force participation rate decrease—from a high of 67.7 per cent in September 2003 to 65.8 per cent in April 2016—is smaller than the corresponding U.S. decline. Furthermore, with a current unemployment rate of 7.1 per cent, there’s more slack in the Canadian labour market than in the U.S.

Given these circumstances, the Bank of Canada is likely to be slow to raise interest rates in Canada, even as rates increase in the U.S. Nevertheless, policymakers in both countries will need to put much more emphasis on supply-side growth policies and rely much less on expansionary monetary policy in their quest to promote faster real economic growth.