U.S.: More Jobs + More Pay = No Inflation: Is The Math Right?

So far, yes. But pressure from the labor markets could change that As irritating as a telemarketer's pitch or as soft as a programmer's keystrokes, the sounds of work are filling offices and factories. They're also echoing through the outlooks for economic growth, inflation, interest rates, and even the federal budget.

Companies added a greater-than-expected 271,000 workers to their payrolls in January, and factory jobs rose for the fourth month in a row (chart). A record percentage of people are in the labor force, and a record number of them have jobs.

However, the steady acceleration in wage growth indicates that the economy is starting to run short of skilled labor. Until this year, strong job growth wasn't a problem given the slack that existed in the labor markets and in production capacity. Now, continued job gains bolster the argument that a strong economy and labor-market tightness will generate sufficient concern about future inflation to force the Federal Reserve to raise interest rates this year.

So far, the data do not provide Fed Chairman Alan Greenspan & Co. with a smoking gun that would justify a change in policy. Productivity is offsetting some of the pay gains. The strength of the dollar, along with the safety valve of excess global capacity, is also diverting some U.S. price pressures. But with the economy in early 1997 appearing to have retained a great deal of its yearend momentum, these offsets are very close to being overpowered.

THE JANUARY EMPLOYMENT REPORT sent mixed signals about first-quarter economic growth. But the jumbled message largely reflects January's weather and the vagaries of the Labor Dept.'s seasonal-adjustment process. The weakest part of the report was a 42-minute plunge in the average workweek, to 34.1 hours. But huge snowfalls and flooding across parts of the U.S. during Labor's survey week kept businesses closed or prevented people from getting to work.

At the same time, payrolls were overstated because five weeks elapsed between survey periods instead of the usual four. Also, severe winter storms in January, 1996, led this year's seasonal adjustment to expect fewer workers, thus exaggerating the rise. Labor officials said the exaggeration was concentrated in temporary-help services but that the overall payroll effect was no more than 50,000, which still leaves a strong gain.

Ultimately, the February and March reports will better characterize the first-quarter job market, and they will likely evince the economy's strength. First, February weather has been milder, so the workweek is sure to bounce back, pulling up total hours worked and weekly pay, both of which fell in January.

In addition, the unemployment rate, which ticked up to 5.4% in January from 5.3% in December, is set to fall, perhaps even below the six-year low of 5.2% it hit last fall. By early February, new claims for jobless benefits, a leading indicator of unemployment, have returned to the low levels of 1996, after being boosted by an auto strike and bad weather (chart). Also, the rate tends to lag behind economic growth, and it has not yet shown the impact of the yearend 1996 speedup.

Moreover, the January uptick in the jobless rate occurred because the healthy job market is drawing more people into the labor force, which posted the largest monthly increase in 2 1/2 years. Some 85% of the entrants quickly found jobs. Right now, the labor force is growing faster than the adult population. That's obviously a temporary situation, as is the resulting boost in the jobless rate.

DESPITE ALL THIS, Wall Street seemed soothed by the January job data. It took particular solace in the noninflationary implications of the slim 0.1% increase in hourly earnings, to $12.06. Prior to the report's release, the bond market had been bracing for a bigger advance in wages. But even so, wages are still up 3.8% in the 12 months ended in January, and that's a six-year high. Manufacturing pay was up 3.4%, while wages in the huge service sector increased by 4%.

The split in wage trends could throw a wrench into any low-inflation forecast. That's because service prices will be more resistant to downward pressures than goods prices. One reason is less competition from imports, a big offset for goods inflation given the dollar's strength. The second reason is that, by definition, services are labor-intensive, so rising wages translate more quickly into service prices.

That is, of course, unless productivity gains offset the pay raises and restrain unit labor costs. But is that happening? Output per hour worked in the nonfarm sector grew at a healthy annual rate of 2.2% in the fourth quarter after no change in the third. Unit labor costs, meanwhile, rose just 1.4% on top of a 3.3% surge in the third quarter. Over the course of 1996, productivity advanced 1.2%, while unit costs rose 2.4%.

While the fourth-quarter productivity numbers look good, the Labor Dept. also says that over the past four years, productivity growth has been anemic. That weakness simply does not jibe with the massive investment in more efficient high-tech equipment of recent years or with reports of stellar profit gains. Service productivity seems to be especially hard to quantify, with the data on financial services particularly dodgy. Because of the growing skepticism about the data, the bond market ignored the productivity report.

LIKEWISE, WALL STREET turned a cold shoulder to the White House's Feb. 6 budget proposals for fiscal year 1998 and beyond--and with good reason. After having their high hopes dashed last year, the markets have taken a "show me the money" attitude this year. But Washington is already off to a bad start. The White House blueprint fails to address the long-term problems of entitlements, which are increasingly on the bond market's mind, and it puts off tough spending cuts until about the time Al Gore will presumably begin his run for the Presidency.

Also, the budget's underlying economic forecast, while not wildly unbelievable, is at least inconsistent (table). The Clinton Administration assumes that short-term interest rates will fall from 5% in 1997 (which, by the way, assumes no Fed tightening this year) to 4% in 2002, but that inflation will hold steady at 2.7%. This implies falling real interest rates in an economy expected to grow at a solid 2.3% per year. That is, the forecast implies that the Fed will be exceptionally accommodating for no apparent reason.

President Clinton's budget plan relies on the win-win-win scenario of strong growth, low inflation, and low interest rates all the way to 2002. But central to that view is the Administration's belief that the current low unemployment rate is noninflationary. Given the way job growth and wage gains are starting 1997, that's a big gamble.

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