Inflation May Be A No Show In This Recovery

Thanks to the April inflation reports, the bond market is beginning to understand that it has nothing to fear from a moderately paced recovery. If future price data continue to pound the lesson home, as appears likely, low inflation will lay the groundwork for a lasting upturn that will take upward pressure off long-term interest rates and the unemployment rate.

The latest data make the case. The credit markets reacted favorably to the modest April increases of 0.2% in both the producer price index (PPI) and the consumer price index (CPI). The rate on 30-year Treasury bonds fell to 7.85% on May 13, on the heels of a larger-than-expected jump in April payrolls and a healthy gain in April retail sales. The numbers on jobs and retail buying were the best signs yet that a modest but sustainable recovery is under way, while the price data show that inflation is under control--and likely to remain so.

The core rates of inflation, measured by both the CPI and the PPI, reveal the fundamentally subdued nature of prices (chart). Excluding the ups and downs in energy and food costs, which can distort inflation's true trend, the CPI rose 0.3% in April--up only 3.9% from a year ago. Yearly core inflation has been under 4% for four months in a row--something that hasn't happened in more than five years. Inflation for the core PPI is running at a four-year low, and no price pressures are building at the earlier stages of production.

The April CPI report looked a lot better than the one in March, when both the total CPI and core inflation rose by 0.5%. But food prices were flat last month, after a spike in March. And apparel costs fell back in April, following March's larger-than-normal gain. Housing costs also moderated in April. That's important since the cost of housing accounts for more than 40% of the overall CPI.


The arguments for continued low inflation are strong and numerous. The most important: For the past three years, the economy has been growing some two percentage points below its long-term potential of about 2.5%. That figure is the sum of the growth rates of the labor force and productivity, and it's the pace at which an economy can grow without fueling inflation. This stagnation has wrung out nearly all of the economy's latent price pressures, and it will take a long time for a mild recovery to generate any new heat under inflation.

Moreover, the wage-price spiral continues to unwind. The pace of wage growth is at a four-year low, and it isn't likely to pick up amid widespread cost-cutting and corporate restructuring. The combination of slow wage growth and the cyclical pickup in productivity that typically accompanies a recovery will restrain the growth of unit labor costs. And it's unit costs that influence prices.

Also, manufacturers still have plenty of idle capacity, so there are no production or distribution bottlenecks to provide the climate for price hikes. Indeed, price wars continue to break out. And last, but far from least, the Federal Reserve is committed to low inflation.

The bond market's expectations of inflation are one factor that has kept long-term interest rates high. In fact, the spread between long and short rates is exceptionally wide. However, the market's fears seem unjustified. More price data like April's will allow inflation expectations--and long-term rates--to adjust downward.


The good news for consumers is that inflation will stay low as jobs and incomes begin to pick up, which will provide a firm foundation for consumer spending.

Retail sales continued to cruise at a high altitude in April (chart). They jumped 0.9%, following a 1% drop in March. A late Easter robbed sales from March, but exaggerated April receipts. Still, retailers are maintaining the lofty sales levels they had reached in February, when buying soared 1.6%, after a 2.1% surge in January.

Even after those big gains, which lifted first-quarter retail sales by an 11.8% annual rate, sales began the second quarter at a 3.1% rate above their first-quarter level. This pattern suggests that consumer buying will continue to add support to economic growth this quarter--but at a more modest pace.

Better job growth will help consumer buying stay on track. The latest employment report was one of the more positive to come out of the Labor Dept. in a long time. To be sure, job growth isn't exploding, but the labor markets are finally showing more strength.

In April, nonfarm payrolls rose by 126,000 jobs--the most in 11 months. And Labor's survey of households--which asks workers, not employers, about jobs--showed a gain of 327,000 new jobs in April, following a 305,000 advance in March. Early in a recovery, the household data tend to lead the payroll numbers, so another healthy gain in May payrolls could be in the works.

More good news: 55.2% of 356 industries added workers last month (chart). Hiring was the broadest in more than two years, and it suggests that the need for labor is picking up economywide. Indeed, last month's jobless rate fell to 7.2% from 7.3% in March.

The trend in part-time work also suggests rising labor demand. The number of people who could find only part-time work fell by 227,000 last month and has dropped by 519,000 since January. This means that companies are extending work time to meet increased demand for their products. And as demand picks up further, companies will hire more employees.

That process already seems to be starting in manufacturing. The factory workweek has stayed at a long 41.1 hours since February, and in April, overtime rose to four hours a week. That's up from 3.7 hours in March, and it's the most factory overtime in three years.

With existing workers putting in so many hours, factories are finally hiring again, adding 8,000 employees in April. While that gain was small, it was the third consecutive advance. Manufacturers haven't added workers for three months in a row since the end of 1988.


The employment report also highlighted some snags that will restrain the recovery. Most important, job growth today is nowhere near its performance in the first year of past recoveries, when payroll gains averaged 190,000 jobs per month and gains of 300,000 or more in any one month were common. Seeking to protect their bottom lines, companies will remain cautious about costly additions to their payrolls.

And the pickup in hiring did not translate to any gains in nonfarm wages, which fell 1 , to an average of $10.54 per hour in April. During the past year, hourly pay is up just 2.5%--the slowest wage growth in nearly four years. While that's good reason to bet against any pickup in inflation, slow wage gains will also put the brakes on any rapid acceleration in consumer spending.

Moreover, because the nonfarm workweek fell by six minutes, to 34.4 hours, average weekly pay dropped by 0.4%, to $362.58. Skimpier paychecks suggest a weak showing for personal income in April.

Still, households are in better financial shape now than they were a year ago. Weekly earnings are up 3.7% from a year ago, more than the overall CPI. In addition, consumers have improved their balance sheets, either by refinancing debts, especially home mortgages, or by keeping their credit cards locked up.

Consumers cut their installment-credit levels by $1.6 billion in March (chart). As a result, credit outstanding as a percent of consumers' disposable income slipped to 16.6% in March--the smallest debt share in seven years. Easier monthly mortgage payments plus lower debt levels are why consumers can lead this economy into recovery even with slow job and income growth.

Of course, debt-shy consumers won't be very extravagant in this upturn. But that's good, because the restraint on spending will squash any demand-driven runup in prices. Bond traders remain a band of doubting Thomases on the prospects of low inflation in a recovery. But given a few more tame-looking price reports, even they may yet become believers.

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