How Labor Shortages Help Profits and Hurt Inflation

(Bloomberg Opinion) -- The U.S. labor market is tight. In April, there were 9.3 million job openings but just 6.1 million new hires, according to the latest Bureau of Labor Statistics. Wages are rising as a result. And yet, these conditions should help corporate profits and contain inflationary pressures.

No doubt there is wage pressures, but mostly in lower-paying hospitality and leisure jobs. With Americans again traveling and eating out, there were 1.59 million job openings in that sector in May versus 851,000 in manufacturing. Weekly wages for hospitality and leisure jobs have leaped 22% from the April 2020 bottom, compared with 9% for the private sector overall from its March 2020 low. One reason why manufacturing wages aren't rising as fast is because globalization has shifted production of goods to Asia, reducing manufacturing employees' share of private sector payrolls to 8.5% from 22% in 1979.

The marketing power of employees has been shifting from manufacturing to services for decades, and the reopening of the economy has accelerated the trend by hyping demand and compensation for workers in lower-paid sectors. It's also forcing manufacturers to raise wages to compete with fast-food job offerings. Nevertheless, this is a rebalancing, not the beginning of a 1970s-style wage-price spiral.

American businesses can't raise prices to offset higher labor costs since that would invite more foreign competition, a force that hadn't yet developed in the 1970s. Also, as the Federal Reserve has noted, U.S. consumers are in a disinflationary mindset and in no mood to accept higher prices. So American businesses have been responding by slashing labor costs and improving productivity. And it has made a virtue out of the necessity of husbanding scarce labor. Since the bottom in the second quarter of 2020, real gross domestic product is up 10.3% but nonfarm payrolls only 7.2%. In the first quarter of this year, nonfarm labor productivity leaped 5.4% from the final three months of 2020 and 4.1% from a year earlier, as reported by the Bureau of Labor Statistics.

From the second quarter of 2020 to the first quarter of 2021, labor productivity in the nonfinancial corporate sector jumped 5.3% while hourly compensation rose 2.0%. In the manufacturing subcomponent, the numbers were 5.5% and 1.2%. Productivity is not only outrunning increased employment but also hourly labor costs.

On an individual industry basis, output gains vastly outran employment increases from the second to fourth quarters of 2020. Airlines' gross output rose 77.3% with only a 4.0% rise in employment. In recreation industries, a 60.7% gain in output required just an 8% increase in jobs. The numbers were 41% and 8% in accommodations and food service and 13.5% and 2.5% in education services and health care.

Most important, these results aren't due to production leverage as underemployed people are more fully utilized. Notice in teh chart below that during the height of the pandemic from the first quarter of 2020 to the second quarter of 2021, payrolls fell 12%, much more than the 9% drop in real GDP.

American business's zeal for cost control and productivity enhancement will continue as lessons from the pandemic persist. And as in the past, productivity gains will be the primary driver of earnings. Over the entire post-World War II era, sales for the corporate sector rose 6.4% per year on average, but labor compensation climbed essentially the same, or 6.3%. So the average 6.5% yearly rise in pretax corporate profits largely was the result of the 2.7% annual climb in productivity.

A statistical analysis reveals that a 1% gain in corporate sales adds 3.7% to profits but a 1% rise in labor costs subtracts 3.6%. So it's left to productivity to boost earnings, with a 1% rise pushing up profits 1.5%.

Productivity gains are not only the key to profits but also the mortal enemy of inflation. More output per unit of input increases the size of the economic pie so employers and stockholders—as well as government taxes—can get bigger slices without hiking prices or even decreasing them. High tech is an easy example since productivity increases have sired high employee pay in Silicon Valley, soaring profits and the collapsing costs of computer power.

Equity investors should zero in on productivity growth prospects of companies since revenue increases in the coming quarters may be disappointing. As discussed in my March 10, 2021 column, consumers—the driving force of the U.S. economy since their spending accounts for 68% of GDP—may continue to emphasize saving, not spending, as they build assets and repay debts. According to the Federal Reserve Bank of New York, they spent only 29% of their March 2020 stimulus checks, 26% of the second round in December of last year and even less, 25%, of this March's money while saving the rest.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, a Registered Investment Advisor and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” Some portfolios he manages invest in currencies and commodities.