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U.S.: A Fine Balance Should Keep This Expansion Aloft

Business Outlook: U.S. Economy

U.S.: A Fine Balance Should Keep This Expansion Aloft

The threat of wage inflation is easing despite tighter labor markets

When economic historians look back at the 1990s, they will no doubt view it as a decade when technology, globalization, and sound monetary and fiscal policies combined to produce the closest thing to price stability since the 1960s. They also will still be arguing about the relative importance of those factors in achieving this no-inflation nirvana.

But what is crucial for the 1999 outlook is that the shift to negligible inflation is the centerpiece of the economy's superior performance in recent years. Low inflation has boosted real pay of workers even as it has forced efficiencies on companies, and it has been central to the ever-rising prices of financial assets--both fixed-income and equity. Most important, unless the inflation outlook changes--and global conditions argue that it won't--the economy should be able to make solid gains well into the new millennium.

On that point, the February employment report offers eye-opening evidence. Despite strong job growth and a 4.4% unemployment rate, hourly wages of production workers are slowing (chart). Last month, pay rose 3.6% from a year ago, down from 4.4% last April--even as labor markets have tightened. With excess production capacity at home and abroad holding down product prices, tight labor markets are the only serious inflation threat. But the latest job-market data take that worry off the table.

WALL STREET KNOWS all too well that low inflation is the butter on its bread. After growing fears that an overly strong economy would force the Federal Reserve to hike rates in order to preserve this Eden, the markets rejoiced over the seemingly benign employment report. The Dow soared ever closer toward 10,000, and the bond market reversed a big chunk of the recent jump in bond yields. The markets are now betting that the Fed will be on hold for the rest of the year.

But at the same time, the employment report was by no means weak. Industries added 275,000 workers to their payrolls last month, and, notably, monthly job growth in the past six months has been even faster than it was in the previous six months. It should be noted, however, that unusually mild weather appears to have exaggerated the February increases in both retail trade and construction. Jobs in retailing rose 123,000, after averaging only 34,000 per month in the previous half year. Construction payrolls increased 72,000, after averaging only 33,000 per month.

To be sure, the economy cannot mine its labor resources ever deeper without risking an acceleration of wage and price pressures. Unless job growth slows, the unemployment rate will slip below 4% by the end of 1999. But even at 4.4%, joblessness is below nearly all previous estimates of the rate at which inflation begins to speed up. Instead, wage growth has slowed.

Why? The most obvious answer stems from the impact of poor global conditions on the prices of U.S. products. Despite ever tighter labor markets, capacity utilization in manufacturing is well below its long-run average and falling. This dichotomy has arisen partly because the world outside the U.S. is flagging, leaving foreign producers only one place to sell their goods--the U.S.--as U.S. exports sag.

This lopsided situation has stripped many companies of pricing power, as global commodity prices sit at a 12-year low. Since businesses cannot pass through cost increases, they are finding ways to avoid paying higher wage rates. That's why 50,000 factory workers lost their jobs in February and why factory wage growth has led the slowdown in overall pay.

That's not to mention the price impacts from the increased inflow of imported goods, made cheaper by the strong dollar. Moreover, the dollar's strength seems unlikely to fade anytime soon. Europe is looking soft. Japan might recover in a year or two. Emerging Asia has stabilized, but recovery prospects are dim. And Latin American conditions are worsening. After falling 10% from August to October, the trade-weighted dollar has regained half of that loss (chart).

RAPID PRODUCTIVITY GAINS cannot be ignored in the no-inflation equation. Indeed, output per hour worked soared at a revised 4.6% annual rate in the fourth quarter, the biggest quarterly gain in six years, bringing growth for all of 1998 to 2.2%. However, productivity growth has not been out of line with what would be expected given the economy's strong growth.

Much has been made of the similarities between the 1990s and the high-productivity, low-inflation 1960s. But back then, productivity accounted for 65% of economic growth, vs. 50% in recent years. Moreover, the volume of foreign trade was only 8% of the economy then. Today, it is approaching 30%, and nearly a third of all nonoil goods bought in the U.S. are imports.

Clearly, strong productivity is restraining unit labor costs, a key to pricing decisions. Fourth-quarter unit costs fell 1.1%, and they rose only 1.9% in 1998. But that pace was faster than inflation, suggesting that the bigger factor holding back inflation is global conditions. The worrisome downside of this price weakness is that profits are under severe downward pressure.

THE LABOR MARKET DATA also show that consumers have been the chief beneficiaries of falling inflation--in two big ways. First, even though workers' hourly pay rose a slim 0.1% in February and 3.6% for the year, that's still far ahead of inflation, so real wage growth now echoes the rapid gains of the early 1970s.

Second, the financial markets have also reveled in low inflation, and consumers have enjoyed a share of Wall Street's good fortune, too. Despite solid growth in purchasing power, consumer spending has grown two percentage points faster than household income, as consumers have taken their traditional savings rate down to zero. Another recent sign of this good fortune: Consumer installment debt ballooned by $15 billion in January, the largest monthly gain in three years (chart), and credit is once again accelerating. Last year, consumer spending and housing delivered 3.7 percentage points of the economy's 3.9% growth.

More than anything, low inflation has set in motion a virtuous cycle of rising purchasing power, growing values of financial assets, and strong domestic demand. At the same time, despite ever-tighter labor markets, weak global conditions continue to restrain prices, keep the dollar strong, and encourage foreign investment in U.S. markets.

But keep one thing in mind: The absence of inflation, which keeps the Fed on the sidelines, is the glue that keeps this virtuous cycle from flying apart. That's not to say the stock market won't have its ups and downs, especially as E-traders in high-tech fuel volatility. But fundamentally, there is nothing on the horizon to suggest that inflation is a threat. So relax--it's starting to look like another good year for the U.S. juggernaut.BY JAMES C. COOPER & KATHLEEN MADIGANReturn to top

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