Ho-hum. Another unexpectedly strong report on the booming U.S. labor market, and another yawn from Wall Street. It's a reaction that would have seemed impossible a few months ago.
Now, though, the bond market isn't worried that February's surging payrolls, tight job markets, and faster wage growth will cause the Federal Reserve to hike interest rates, as long as the Asian crisis keeps the economy from overheating. And the stock market, while nervous about the tech sector, seems to think that rising labor costs amid little pricing power is no great threat to profits. It seems as if nothing can crack Wall Street's tough veneer.
To be sure, the outlook for inflation overall in 1998 is very good, thanks to the effect of Asia's collapse on the surging dollar, the ensuing weakness in commodity prices generally, and the sharp drop in oil prices in particular. Lower materials costs will also help the bottom lines of many businesses at a time when profit growth is slowing.
However, look at what else is happening. Because of low inflation and faster wage growth, the real wages of American workers are rising at nearly 3% per year, the fastest pace in decades (chart). That's the chief reason why consumer spending remains surprisingly strong. But while these are heady times for workers, businesses cannot keep paying out increases in real wages in excess of their advances in productivity without seeing their profit margins suffer.
In fact, the crucial determinant in the 1998 outlooks for profits, inflation, monetary policy--and Wall Street--will be the success of U.S. corporations in managing their labor costs. And judging by the February report from the labor markets, companies have their work cut out for them.
NOT ONLY DID JOB GROWTH continue to be nothing short of phenomenal in February but the unemployment rate also dipped back to a 24-year low of 4.6%, from 4.7% in January. And there is every reason to believe that it will go lower. At the growth rates of employment and the labor force during the past six months, the jobless rate would fall below 4.5% by summer.
But the biggest surprise last month was another large gain in payrolls, which rose by 310,000. Jobs in the service sector continued to lead the growth, although strong homebuilding, coupled with mild weather and cleanup efforts after flooding and ice storms, boosted construction employment. During the past four months, job growth has averaged 367,000 net new hires per month, the most for any such period since 1984. And in the past half-year, jobs have increased by 2 million (chart).
Amid continued pressure to find workers, companies increased the average hourly wage rate by 0.6% in February, to $12.60, and pay in the service-producing industries increased by an even greater 0.8%. Those advances lifted the annual clip for overall wages to 4.1% from a year ago, and service-sector pay is rising at a 4.5% pace. Adjusted for inflation, using the chain-weighted price index for consumer goods and services, real wages are up 2.9% from a year ago, the fastest pace since 1974.
GAINS IN REAL PAY have further to run this year. With the domestic economy so strong, labor markets are almost certain to remain very tight. Not only will pay gains continue to pick up, but with inflation set to remain low, any addition to the pace of pay will transmit immediately into real wage growth.\
In particular, lower oil prices have already provided a sizable anti-inflation impact, which should continue this year. Cheaper oil cut 0.2 percentage points from the 1997 inflation rate, and the 1998 impact could be twice that. Crude prices fell from more than $26 per barrel at the end of 1996 to $18 at the end of 1997. So far in March, prices have dropped below $15, a four-year low, with further declines likely. OPEC continues to produce beyond its quota, and the collapse in Asian demand has created a worldwide glut that will not be soaked up anytime soon.
Of course, if businesses are getting 2.5%-to-3% productivity growth from their labor, then real wages can rise that fast without squeezing profit margins. There's the rub. Productivity growth in the past two years has averaged a stellar 1.9% annually, but even at that pace, it has started to fall behind real pay gains, and it may well stay behind throughout 1998.
Nonfarm productivity growth in the fourth quarter of last year was revised down from a 2% annual rate, to 1.6%, but even that healthy pace could not prevent unit labor costs from rising at a 3.5% annual rate. That's because fourth-quarter compensation jumped 5.2%, the most in any quarter in nearly six years.
Moreover, based on labor market data through February, unit labor costs appear to have increased even faster in the first quarter. Hourly pay in the first quarter is rising at an annual rate of 4% through February. Meanwhile, hours worked are on a track to rise at an annual rate of about 5.5%, which should swamp the likely growth in output. That means there will be little if any gain in productivity to prevent higher pay from feeding directly into unit labor costs.
THE HOPE ON WALL STREET is that Asian weakness will cool off overall demand, thus easing labor market pressures. But so far, there is no evidence of that. Clearly, softer Asian demand is showing up in the manufacturing sector. Factory orders rose 0.5% in January, bouncing back from a December drop caused by a swing in aircraft orders. But the trend in bookings excluding planes has fallen off in recent months (chart), in tandem with signs of weaker export orders.
Moreover, the February employment report showed that manufacturing payrolls dipped slightly, after four months of solid gains. Also, the factory workweek, often a leading indicator of employment, declined for the second month in a row. Factory production, while growing more slowly this quarter, compared with the fourth quarter's 8% annual rate, still appears to be increasing at a moderate pace of about 4%.
But because the overall labor market remains so strong, consumers are leading unrelenting strength in domestic spending, especially in services. In turn, intense demand for labor continues to fuel real wages--and even more spending. The outlook for 1998 may well turn on how this virtuous cycle plays out.
The most likely scenario: As long as businesses lack pricing power, this cycle is self-limiting. That's because profits will get squeezed. Capital spending will suffer. Employment will slow, and the economy will cool down on its own. So if you're a worker, enjoy the good times while they last. But if you're an investor, you should worry that those good times might come at a hefty cost to Corporate America.