Covid caused huge shortages in the jobs market. It may be easing — but there's another problem ahead

Since the onset of Covid-19, labor shortages have plagued major economies and intensified inflationary pressures, but economists expect this trend to finally abate this year.

Central banks around the world have been tightening monetary policy aggressively for over a year in a bid to rein in sky-high inflation, but labor markets have by and large remained stubbornly tight.

Last week’s U.S. jobs report showed that this remained the case in April, despite recent turmoil in the banking sector and a slowing economy. Nonfarm payrolls increased by 253,000 for the month while the unemployment rate was at its joint-lowest level since 1969.

This tightness is reflected across many advanced economies, and with core inflation also remaining sticky, economists are divided as to when the likes of the Federal Reserve, the European Central Bank and the Bank of England will be able to pause, and eventually cut, interest rates.

In the U.S., the Federal Reserve last week signaled that it may hit pause on rate hikes, but markets remain uncertain as to whether the central bank will have to nudge rates higher still in light of incoming data. Job openings in March fell to their lowest level in nearly two years

However, Moody’s projected last week that the gap between labor supply and demand is expected to narrow across G-20 (Group of Twenty) advanced economies this year, easing the labor market tightness as growth slows with the lagged impact of tightening financial conditions and cyclical demand for workers recedes.

In mid-2022, supply chain shortages that arose in the wake of the pandemic transitioned to gluts of goods and materials for retailers and manufacturers, as bottlenecks and a resurgence of demand moderated.

Jeffrey Kleintop, chief global investment strategist at Charles Schwab, expects a similar reversal in the labor market later in 2023, once the lagged effect of monetary policy tightening takes hold.

“Company communications on earnings calls and shareholder presentations reveal a rising trend of mentions of job cuts (including phrases like ‘reduction in force,’ ‘layoffs,’ ‘headcount reduction,’ ’employees furloughed,’ ‘downsizing,’ and ‘personnel reductions’) along with a falling trend in mentions of labor shortages (including phrases like ‘labor shortages,’ ‘inability to hire,’ ‘difficulty in hiring,’ ‘struggling to fill positions,’ and ‘driver shortages’),” Kleintop highlighted in a report Friday.

Data aggregated by Charles Schwab showed that in U.S. corporate earnings since the start of this year, phrases relating to workforce reductions began to exceed those relating to labor shortages for the first time since mid-2021.

‘From shortages to gluts’

Kleintop also cited tighter lending conditions as contributing to a weaker jobs outlook, pointing to a “clear and intuitive leading relationship between banks’ lending standards and job growth.”

“The magnitude of the recent tightening in lending standards from banks in the U.S. and Europe points to a shift from job growth to job contraction in the coming quarters,” he said.

Falling demand for labor will be the main driver of further reversals over the next three to four quarters, Moody’s suggested on Friday, while rising borrowing costs for firms and households will reduce hiring intensity, consumer spending and economic activity over the course of the year.

“Modest growth in labor supply will also ease shortages, driven by higher participation rates from younger worker cohorts and fading pandemic-related frictions,” Moody’s strategists said.

“Labor force participation rates for age cohorts under the age of 65 have returned to (or in some cases surpassed) their pre-pandemic levels in most G20 AEs (advanced economies), indicating that the last two years of strong wage growth have been largely successful in enticing workers back into the labor force.”

Services job growth has been a key factor behind labor market resilience in the face of global economic weakness over the past year, as a result of a post-pandemic surge in demand.

Charles Schwab’s Kleintop highlighted that the gap between the services and manufacturing PMI (purchasing managers’ index), which is in recession, is at its widest on record.

“The record-wide gap between growth in services and weakness in manufacturing suggests an imbalance that may need to readjust,” he said.

“It may be the strength in the services economy—and therefore jobs—if the lagged impact of bank tightening begins to have more of an impact.”

This weakening of the job market picture may help central banks that have long voiced concern about the potential for tight labor markets and stronger wage growth to entrench inflation in their respective economies.

It may allow policymakers to adopt a more dovish stance, Kleintop suggested, which would boost stocks.

“However, the shift from shortages to gluts in the labor market may not be fast enough to bring down core inflation materially by year-end to allow central banks the freedom to declare victory over the drivers of inflation and begin to cut rates aggressively,” he added.

Risk of resurfacing

Although they agreed that labor shortages in advanced economies will subside this year, Moody’s strategists suggested it could resurface without meaningful policy action to grow the size and productivity of the labor force, as population aging continues to shrink workforces.

The ratings agency said aging will lead to a strong decline in available labor supply for most advanced economies, with South Korea, Germany and the U.S. particularly affected.

Based on estimates of labor supply lost to aging since the Covid pandemic, Moody’s believes the coming drag will be “significant.”

In the U.S., Moody’s estimates that aging is responsible for nearly 70% of the 0.8 percentage point decline in the labor force participation rate from the final quarter of 2019 to now, representing a loss of around 1.4 million workers due to aging.

“This ‘demographic drag’ on participation rates has been most significant in the euro area, Germany and Canada. However, idiosyncratic factors and policy action in France, Australia, Korea, the euro area and Japan have been able to offset their recent demographic drag,” Moody’s strategists said.

Offsetting factors they identified through data since the turn of the century included gains in female labor participation, migration, and progress in technology and training.

“As a result, policies that encourage immigration, female labor participation or the uptake of new, productivity-enhancing technologies will determine the extent and persistence of labor supply challenges. Without them, we would expect hiring challenges to re-emerge in the next business cycle,” Moody’s strategists argued.