The Future Is Brighter For Workers But Dangerous For Bond Investors

Would you rather be looked after in your old age by your kids or robots?

For me the answer is easy – robots. They won’t forget my meds, are good at tidying up and, with only a modicum of improvement in artificial intelligence, are likely to have more empathy.

The Japanese are not so sure. But faced with the world’s oldest population and a shortage of care workers, they have no choice but to experiment. In one pilot program they paid $1,000 to nursing homes that agreed to use a robot for certain basic functions – helping patients get around, changing sheets, etc.

The results? Employee overtime declined as the robots helped ease the workload. But hospitals still needed to employ the same number of nurses. Turns out the robots were, like my children, not particularly empathetic. Nurses were needed to comfort patients and, more generally, were able to refocus their time to improve quality of service. An encouraging win-win.

This is just one of several fascinating stories that emerged from my conversation this week with Manoj Pradhan on the Top Traders Unplugged podcast. Pradhan is the ideal person to speak with about these topics because he co-authored The Great Demographic Reversal, which explains how population demographics are going to impact markets and economies over the next several decades.

Power Back To The People

Pradhan expects inequality to wane as power shifts back to labor, particularly those in the bottom half of the income distribution. There is evidence this is already happening. Take a look at the graph below, which I generated using data from the Atlanta Fed. For virtually the first time in the last quarter-century wage rates for low-skill workers are rising faster than for high-skill workers.

As we discussed this on the podcast I pounced at the chance to retell an anecdote I’ve been boring dinner party guests with for several months. A resort in the rural West Coast has been struggling to find cleaners. They raised hourly wages multiple times, eventually finding a level where locals began filling the positions, which pre-pandemic were mostly held by foreigners on seasonal work visas. For a time the line managers were happy – they weren’t making beds anymore. Then someone did the math and realized the cleaners, when you annualized their pay, were making more than the mangers. The managers then bargained for a raise…and we start to see how inflation takes hold.

Pradhan countered with a story of his own – his wife’s firm has seen junior managers leaving her industry entirely. Why? Because entry-level, low-skill wages in other sectors offer better pay and more flexibility. To keep workers her firm too needed to offer higher salaries. This shows how a shortage of labor in one sector can spread higher wages to other areas which on first glance shouldn’t be impacted. (Califorina taxpayers reading this need not fret, this higher-wage wave has not yet reached the shores of my employer, U.C. Berkeley).

Forcing The Fed’s Hand

When I wrote about Pradhan’s book last summer I suggested that markets were going to be caught off guard by this emerging inflationary pressure. The “inflationary earthquake” that I predicted has come to pass this year. While Pradhan hasn’t been surprised by inflation taking center stage, he did not anticipate that the markets would treat the Fed like an emerging market central bank.

In the autumn of 2021 markets became concerned that the Fed was too sanguine about inflation. Its view was – “if you won’t do something, we will” – and 1-year interest rates shot up in response. For a while the Fed clung to its view that inflationary pressures were temporary, and longer-term inflation expecations under control, but eventually its hand was forced and it had to start raising rates aggressively.

That’s an unusual thing to happen. Although the Fed doesn’t directly control them, 1-year interest rates largely reflect the expected path of rates that it does control. If the Fed wants to keep 1-year rates low, it almost always can.

That won’t work in an emerging market because if the central bank is seen as too complacent about inflation, investors start selling government bonds and interest rates rise on their own, exactly what happened this year in the U.S. (and Europe, Australia, etc.) Markets demanded higher rates and got them.

This battle isn’t over – it will eventually shift to the longer end of the yield curve. Pradhan argues that central banks need to learn to “live with” higher inflation”. But will markets let them? They forced up short-term rates this year and could eventually do the same to long-term interest rates. That would be a real problem in a world where U.S. debt relative to GDP is projected to almost double from current levels by 2050 (see graph below).

Quantitative Easing: You Ain’t Seen Nothing Yet

Why is U.S. debt expected to rise so dramatically? It’s mainly due to the demographic forces discussed in Pradhan’s book – higher health care and pension costs. Of course, the government could say “sorry, you’re on your own here, pay for it yourself”. But if this happened we’d all have to save so much that we’d stop spending on other stuff – economic activity would collapse. Not great. Governments will therefore finance some, probably a lot, of these costs.

They could finance them by raising taxes. Pradhan believes that is unlikely because workers will say, wait, if you’re going to raise my taxes to pay for all these old people I need a pay raise. A fair point and if followed through could quite easily generate a spiral of inflation in a world already beset with inflationary pressure. Also not great.

Instead, he thinks governments will finance the increased spending by selling bonds which the Fed will buy. When those bonds come due, the Fed will just agree to buy new ones to replace them – basically a quasi-permanent form of QE.

From the government’s perspective the goal would be for Fed buying to keep long-term interest rates somewhat below the rate of inflation, so that the real burden of the increased debt would eventually be reduced. Of course, that’s not a great scenario for anyone else who owns government bonds and, logically, anyone who has a choice will avoid them. That means the Fed and other government-controlled entities could end up being most of the market.

There are other knock-on effects from continual Fed buying of bonds that I will be writing about next week (yes, that’s a teaser). And there are changes we can make to incentives and taxes that might lead to more growth, which would make paying for the impact of aging a bit easier (another teaser). But Pradhan has laid out a thorough and logical long-term base case: a better future for workers and a dangerous one for bond investors.