The recovery is three years old this month. From its shabby beginning, it has grown into a solid expansion that now garners rising optimism from households and businesses, respect from the Federal Reserve, and fear from the bond market. The question now: Is the economy growing too fast to contain inflation?
The recent strength is impressive. Following last quarter's 7.5% growth rate, the economy has retained considerable momentum this quarter, especially in the consumer sector. The index of leading indicators continued to rise in January, helped by a sizable contribution from materials prices. And the Labor Dept.'s new measure of joblessness has fallen sharply, suggesting that full employment, and thus wage pressures, may be closer than previously thought (chart).
However, all this ignores two important differences between this expansion and those in the past. First, productivity growth has accounted for a larger share of economic growth during this recovery than in any of the upturns since 1960--and by a wide margin. And second, in no previous expansion has the pricing power of U.S. companies been so limited by global competition. That's why, this time, the economy can enjoy a solid expansion while generating far less price pressure in the process.
Indeed, in January and February the Federal Reserve found "only limited price pressures" in its survey of regional economic activity prepared for its Mar. 22 policy meeting. At the same time, the Fed noted that the economy "expanded moderately" despite unusually severe weather in the East and Midwest. It also said that manufacturing activity increased and merchants expect "solid sales growth in coming months."
Judging by the Labor Dept.'s latest reports on employment and productivity, this happy blend of solid growth and low inflation should continue. Despite more cold and snow, U.S. payrolls bounced back from their weather- and earthquake-depressed showing in January. Industries added 217,000 jobs in February, after no growth in January. In the past six months, job growth has averaged 170,000 per month, and the gains have been the broadest in five years.
The Labor Dept. noted that some of the February rebound reflected the return of workers that nature had waylaid in January. However, Labor said the weather also hit February employment in manufacturing, construction, and in several service categories, such as amusement and recreation. As a result, job growth in March could be quite strong, given normal weather.
The winter storms especially left their mark on hours worked. The workweek dropped from January's five-year high by 30 minutes, to 34.3 hours in February. Weekly hours in manufacturing plunged 42 minutes, to 41.1 hours, from January's record high. Lost work time should be recovered in March; so too for output and pay.
One of the most impressive features of the February job report was the drop in the unemployment rate to 6.5%, from 6.7% in January. Using Labor's more accurate measure, joblessness has fallen by a full percentage point during the past six months, a considerable tightening in labor market conditions over such a short span.
Does that mean faster wage growth is about to set the wage-price spiral in motion? Not likely, at least for 1994. One reason: Productivity gains are holding down unit labor costs, especially in manufacturing, removing some of the need for companies to hike prices. Besides, resistance to higher prices remains strong.
Fourth-quarter productivity growth was stunning. Revised data show that nonfarm output per hour rose at an annual rate of 6.1%, instead of 4.2% as originally reported. It was the best quarterly performance in eight years, and it followed a 4% jump in the third quarter. Since wages and benefits rose 2.8%, unit labor costs fell 3.1%, the largest drop in a decade (chart).
In economics, productivity-driven growth is as close as you get to a free lunch. Consider the manufacturing sector. The jobless rate dipped to only 6.1% in February, and annual growth in factory wages has accelerated to 3.5%, from 2.3% six months ago. With inflation less than 3%, real factory wages are now rising.
But because of the productivity push, including a 7.2% surge in the fourth quarter, factory unit labor costs have declined 2.8% over the past year. As a result, factories can raise workers' real wages without big hikes in prices and without taking a bite out of their profits.
If wage pressures are going to emerge, they are most likely to show up first in the service sector, where productivity gains have been less dramatic and where there is less global competition than in manufacturing.
Even so, productivity growth has been sufficient to hold the pace of service-sector unit labor costs to about 2% during the past year, the slowest in decades. And joblessness in services, at 6.5% in February, should decline more slowly than in manufacturing, since efforts to increase service efficiency lag behind those at factories.
That lag is one reason why factory workers have garnered better pay raises than those in services, which employ nearly 80% of all workers. As a result, hourly wage growth in the total nonfarm sector has averaged about 2.5% for two years. So far in this expansion, most employees have been able to boost their weekly pay only by putting in a longer workweek.
In February, the shorter nonfarm workweek offset a 0.2% rise in hourly pay, so the average weekly paycheck dropped a sharp 1.3%. The fall suggests the wage and salary component of personal income was weak last month, although a rebound from the losses caused by the earthquake should help to lift overall income.
Looking ahead, a greater demand for labor means that skilled workers in both manufacturing and services may finally see bigger pay raises this year. If so, fatter paychecks may replace last year's wave of mortgage refinancings as the fuel for consumer spending. The Federal Reserve's regional survey also noted that rising interest rates have already slowed refinancing activity.
Still, consumers were off to a hot start in 1994. Their spending in January began the first quarter at a 3.7% annual rate above the fourth quarter, proving that neither rain nor sleet nor earthquake tremors will keep shoppers from their appointed rounds.
Moreover, the latest spending news looks equally impressive. Purchases of U.S.-made cars and light trucks rose 1.3% in February, to an annual rate of 13.4 million, the highest pace in more than four years (chart). And the Johnson-Redbook Report, published by Lynch, Jones & Ryan Inc., shows that sales at department and chain stores held steady last month, and then rose 0.7% in the first week of March from February's average.
Likewise, consumers have not pulled back on borrowing. Installment credit rose $6 billion in January, the seventh consecutive month that debt increased by more than $5 billion. About half of the $44 billion borrowed since July has come from revolving debt, which includes credit cards, although revolving credit is only ene-third of total debt outstanding (chart).
The ratio of debt to disposable income rose to 16.5% in January. But that reflected the earthquake-related fall in personal income rather than any debt problems building in the household sector. For the rest of the year, installment debt should keep rising in line with income gains.
Rising income levels and increased borrowing, together with steady job growth, suggest that consumer spending may be more of a power in the U.S. economy this year than was anticipated. However, as long as these same consumers are more productive at work, it is hard to argue that a quicker pace of domestic demand will lead inexorably to a faster pace of inflation.