Strong growth and low inflation have become ingrained in the way most analysts view the U.S. economy. This win-win combination was a hallmark of the late 1990s, and it has been true for the past two years. However, the ground is slowly shifting, and the forces that have held inflation down for so long are starting to move in the opposite direction.
It's not as if inflation is about to skyrocket. Competition is too intense to allow that. However, some caution flags are popping up. Most important, labor markets are tightening, the dollar has fallen for three years, to a seven-year low, and productivity growth has slowed sharply. Why is this important? Because when the labor markets were tightening in the late '90s, it was a rising dollar and strong productivity growth that held inflation in check. If the economy is as solid as recent data suggest, then 2005 will offer a crucial test of just how much this new age of global competition can continue to keep price pressures under wraps.
Both federal reserve policymakers and bond investors have a lot riding on the outcome. Right now, the Fed and the bond market seem pleased with the economy's resiliency. But the next few months could test both the bond market's contentment and the Fed's gradualist approach to tightening policy. The Fed's six rate hikes since last June have had almost no impact on the bond market, a key factor that has kept borrowing costs unusually cheap for home buyers and businesses. But the minutes of the Fed's Feb. 1-2 policy meeting showed some concern among some policymakers that the declining dollar and higher unit labor costs could heat up price pressures.
The minutes also suggested that the pace of further hikes will depend greatly on how the economic data shape up. On that front, although the economy was expected to cool off a notch this winter, the January and February data from housing starts to factory output to retail sales show little, if any, loss of momentum. That suggests real gross domestic product could be expanding close to its roughly 4% annual rate of growth posted in the second half of 2004, a pace that will continue to imply strong demand and tighter job markets.
Already, the news on inflation is starting to hint that demand is robust enough -- and the dollar low enough -- to generate upward pressure on goods prices. A return to $50 oil in recent days and new jitters over the dollar have made matters worse in the financial markets. Stock prices plunged on Feb. 22, with the Dow Jones (DJ) industrial average suffering its worst loss in nearly two years on fears that costlier oil and a sinking dollar would fuel inflation. Bond prices also buckled, pushing the yield on 10-year Treasuries to a six-week high of 4.29%.
But the number that drew everyone's attention most recently was the 0.8% surge in the January producer price index for core finished goods, which excludes energy and food. True, several apparent one-time price jumps for cigarettes, alcoholic beverages, and automobiles were factors, but those gains do not explain all of the unexpected increase. "People are paying a lot more for our products than they have in a long, long time," says Andrew N. Liveris, CEO of Midland (Mich.)-based Dow Chemical Co. (DOW), the country's largest chemical maker. Dow has raised many prices by more than 30% over the past year and has no plans to stop.
Rising business confidence and the capital-spending boom are also pushing up prices for basic equipment. Caterpillar Inc. (CAT), the Peoria (Ill.)-based maker of heavy machinery and engines, also has been jacking up prices. It began the year with the third price hike in 12 months, so that its products now cost, on average, about 9% more than a year ago. "It's our plan to more than offset material cost increases with prices in 2005," says Douglas Oberhelman, Caterpillar group president.
Higher import prices, the result of the dollar's three-year drop, were another driver for the PPI gain. Not only is the yearly inflation rate for nonoil imports up to 3%, from -5.1% at the dollar's peak three years ago, but costlier imports are also giving U.S. producers some leeway to lift the prices of their own goods as well. For now, that's mostly true in the area of raw materials and supplies used by U.S. manufacturers.
Take Eaton Corp. (ETN), a diversified manufacturer headquartered in Cleveland. Last year, its outlays on steel and other metals jumped by $140 million. The company was able to offset only about half of that through other cost cuts and some price increases and had to take the rest out of profits. It doesn't intend to do that again this year. With others making similar moves, government data show that prices of semifinished goods, even excluding energy and food, jumped sharply in January, and their yearly inflation rate is now 8.5%, the highest since the early 1980s.
THE "CHINA EFFECT"
Of course, a lot has changed since the early '80s. Passing those costs through to consumer prices is much more difficult today in the face of intense global and domestic competition. Despite the dollar's drop, prices of imported consumer goods, excluding autos, are up a scant 0.8% from a year ago, and imported autos are up only 1.6%. That partly explains why, despite the PPI jump, the January consumer price index rose a scant 0.1%. Even stripping out energy and food, which often say more about supply conditions than underlying inflation pressures, the CPI rose only a tame 0.2% for the fourth month in a row.
So far, the "China Effect" has been the biggest factor holding back overall import prices, reflecting China's rigid currency peg to the dollar. During the past year, prices of imports from industrialized nations are up 6.7%, but prices of Chinese imports are down 0.7%. Any revaluation of China's currency could have a sizable impact on overall import prices -- and U.S. inflation.
Even Fed Chairman Alan Greenspan noted in his Feb. 16 congressional testimony that foreign exporters to the U.S. have reached the limits on how much they can absorb the stronger dollar in their profit margins, suggesting that more rapid increases in import prices could be on the way.
The other caution flag is the slowdown in productivity growth at a time when job markets are finally beginning to tighten. In 2004's fourth quarter, output-per-hour-worked rose by just 0.8% at an annual rate. Although that number is likely to be revised a shade higher, productivity gains for all of 2004 will probably average about 2% per quarter, the slimmest average in four years. For the Fed and the bond market, the question is whether the efficiency slowdown will cause unit labor costs to rise to the point that businesses feel the need to raise prices to hold their profit margins. Already, the growth in labor costs has outstripped productivity gains in each of the past three quarters, the first time that has happened in five years.
With productivity slowing, businesses will have to add to their payrolls at a faster clip to meet increased demand. Plus, the labor market may well be tightening faster than recent job data suggest. New unemployment claims this year have moved sharply lower, with new filings in mid-February hitting their lowest level in more than four years. Moreover, the Conference Board's February survey of consumer confidence showed that the percentage of consumers describing jobs as "hard to get" fell to the lowest level since 2002. Households also described present economic conditions as the best in 3 1/2 years. Based on past trends, a surge in consumers' assessment of current conditions has always been linked to a pickup in job growth, and job trends will weigh heavily on both wage growth and the Fed's future interest-rate moves.
To be sure, globalization continues to be a formidable force holding back U.S. inflation pressures. But this year, the economic winds are gradually beginning to blow in the other direction. How strong those gales turn out to be will determine whether the economy faces clear sailing or rough seas.
By James C. Cooper and Kathleen Madigan, with Michael Arndt in Chicago and Rich Miller in Washington