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Lower Sales, Higher Profits?

Economic Trends


One economist sees a link

It sounds paradoxical, but at least one economist argues that the profits boom of the 1990s was caused in part by a historic collapse in the growth of business sales. According to James Paulsen, chief investment officer of Norwest Investment Management Inc., the lack of good top-line growth forced managers to undertake the restructurings that boosted productivity and held down inventory and compensation costs. The result: strong earnings.

Paulsen points out that since 1990, sales have grown at an average annual rate of just over 5%, the slowest pace of the post-World War II era. Nevertheless, profits have boomed by more than 10% annually, the strongest decade since the war. In the 1960s, by contrast, annual sales grew at a rate of almost 7%, while profits rose at less than a 6% annual rate.

But Paulsen frets that today's optimistic atmosphere is not sustainable. He notes that real gross domestic product has grown at just 2.3% annually this decade, far below the 3.6% postwar average. Even job growth has averaged a modest 1.7% a year. "The persistent decline in top-line sales growth simultaneously explains record-setting profit and stock market performance combined with disquieting indicators of economic weakness," Paulsen says.

His biggest fear: true deflation, as prices collapse in the face of continued weak demand. To Paulsen, continued price weakness suggests that bond yields are far too high. He sees the long treasury bond settling in at as low as 4%, compared with today's 6%. But he notes that despite the fundamental weakness of sales, stock prices should continue to rise as interest rates fall.BY HOWARD GLECKMANReturn to top


A Fed bank sees higher prices

Not everyone is sold on the idea that the war against inflation has finally been won. The Federal Reserve Bank of Cleveland has tweaked the government's traditional measure of consumer prices and concluded that the U.S. may be a lot further from price stability than most analysts think.

The Bureau of Labor Statistics calculates the consumer price index as the weighted mean--or the average--of the prices of 36 product categories. By that measure, the annual inflation rate has fallen to barely 2%. But the Cleveland Fed publishes an alternative measure of inflation based on what it calls the median CPI, originally proposed by economists Michael F. Bryan of the Cleveland Fed and Stephen G. Cecchetti, now research director of the New York Federal Reserve.

The median CPI effectively discounts the most extreme fluctuations in consumer prices, which understate the overall rate of inflation. For example, over the past year, the prices of products such as fuel and used cars have fallen sharply, which has tended to pull down the government measure of inflation. By contrast, the median CPI gives less weight to these large but possibly isolated declines.

The effect of such a change is dramatic. From October, 1997, to March, 1998, the government's measure of CPI barely budged--rising, on average, less than 0.1% a month. But according to the Cleveland Fed's measure, prices rose more than twice as fast. In March alone, officially measured CPI was flat. Even when you exclude volatile food and energy prices, the CPI shows only a modest 0.1% hike. But median CPI spiked by a startling 0.3%, or an annual rate of 4%.

Cleveland Federal Reserve Bank economists argue that their median-CPI method is a more accurate predictor of inflation and is more closely tied to the growth of money in the nation's economy. But despite Cecchetti's influential position, they are still a long way from convincing colleagues at the Federal Reserve, where governors, including Chairman Alan Greenspan, are said to be skeptical.BY HOWARD GLECKMANReturn to top

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