At Least We Don't Have To Worry About Inflation

Households have little to cheer about in these days of job insecurity and heavy debts. They can't even enjoy the lowest inflation rate in years, mainly because today's tame behavior of prices is the result of a stagnant economy and weak labor markets. However, the good news is that low inflation is going to be around well after these trying times have passed.

Simply put, the U.S. economy cannot generate price pressures when it is growing below its long-term potential of about 212%. That figure is the sum of the growth rates of the labor force and productivity, and it's the pace at which the economy can grow without fueling inflation. Since the first quarter of 1989, real gross domestic product has grown at an annual rate of only 0.5%. During the past year, real gdp is up 1.5%.

Inflation will stay down mainly because this unprecedented period of stagnation is forcing Corporate America to focus on boosting productivity. Already, productivity gains, combined with the slowdown in wages and benefits, have resulted in the slowest annual growth of unit labor costs in eight years--and it's unit costs that influence pricing decisions.

Moreover, many of these productivity gains appear to be permanent, not just cyclical. Companies are eliminating many positions and costly overhead. That's painful, but it means that unit labor costs--and inflation--are likely to stay low well after wages and benefits begin to pick up again as the economy gets back on track.


But that might take a while. A true recovery now seems more likely to come together in 1993 than in 1992. Except for the price indexes, the economic data for August look uniformly disappointing--if not alarming. They suggest that the economy will remain in limbo between recession and recovery through yearend.

Indeed, corporate economists are lowering their forecasts (chart). Those who gathered in Dallas on Sept. 13-16 for the annual meeting of the National Association of Business Economists now expect growth in 1992 of 2.3%, compared with the 2.6% they had projected back in May. Growth will pick up modestly in 1993, they say, to 2.8%.

That pace is fast enough, they believe, to nudge the jobless rate down to 6.9% next year, from 7.4% this year. But it is slow enough to keep inflation under wraps. The forecasters look for the consumer price index to rise 3.5% in 1993, a shade above the 3.2% expected for 1992. But both of those numbers might well be too high.

One new question mark in the outlook is the currency crisis in Europe. The European Monetary System unravelled on Sept. 16, when Britain and other countries allowed their currencies to float freely, thus abandoning the European exchange rate mechanism.

Despite the new turmoil overseas, financial markets in the U.S. are expecting yet another easing move by the Federal Reserve, amid the latest signs that the economy is still floundering. Investors anticipate a half-point cut in the discount rate, to 212%, and another quarter-point trimming of the federal funds rate by early October.


If the Fed decides to move, inflation worries will not stand in the way. The August price indexes make it clear that inflation isn't even an issue at either the wholesale or the retail level. Producer prices of finished goods rose a scant 0.1% last month, and there were no signs of price pressures at earlier stages of production. During the past year, wholesale inflation stood at 1.5%.

The news on consumer inflation is even better. The consumer price index rose by 0.3% in August, but the core rate was up only 0.2%. The core rate excludes food and energy, which can distort the cpi's true trend. Yearly core inflation is now 3.5%. That's the lowest pace in nine years (chart). If core inflation falls below 3.1%, which seems likely by next year, you will have to go back two decades to find a lower rate.

The drop in the core rate says that inflation improvement has been broad. A year and a half ago, core inflation was 5.6%. Since then, price hikes on everything from air travel to zinfandel have gotten smaller, and even stubborn service categories, such as insurance premiums and doctors' fees, also have given some ground.

Service inflation had been the main barrier to lower inflation generally, because services make up 55% of the cpi. But in August, they rose a modest 0.3%, and yearly service inflation is only 3.9%. That's down sharply from 6.2% a year and a half ago. Service inflation is also the lowest in nine years, and it will stay low if service companies can hold on to the productivity gains made in recent years.

As for goods, don't expect prices to speed up until demand--and output--strengthen enough to dust off the cobwebs now gathering on industry's unused capacity.


Clearly, that isn't happening in the third quarter. Factories, mines, and utilities cut their output by 0.5% in August, the second drop in industrial production in the past three months. Manufacturing output fell 0.3% in August, and it is hardly above its level of a year ago, when it had fallen 2.4% in the previous 12 months.

The falloff in production has caused more and more capacity to be mothballed. Operating rates for all industry fell to 78.5% last month, from 79% in July. Capacity usage had recovered in the first half of the year, but now companies are cutting back once again. In particular, factory operating rates slid to 77.5% in August--the lowest rate since March (chart).

Low capacity rates brighten the inflation outlook because companies don't dare risk losing scarce customers by raising prices. That would only idle even more equipment. Slack capacity is also why factories are cutting back on their investments on new plants and equipment.

In the Commerce Dept.'s latest survey of capital spending plans, businesses expect just a 4.3% increase in outlays this year. That's better than the 0.8% decrease in 1991, but it's down from the 4.7% increase planned when the government took the last survey in the spring. The cutback comes despite lower interest rates, improved cash flow, and healthier balance sheets.

The broad category called nonmanufacturing is providing all of the spending gains this year, with a planned rise of 8.1%. That likely reflects a move by service companies to boost productivity rather than expand payrolls.

Manufacturers, however, continue to cut their capital budgets. Spending will fall by 2.9% this year, on top of a 5.1% drop in 1991. No turnaround in outlays by manufacturers is likely until demand shows more life.

Of course, manufacturers aren't the only ones reeling from weak consumer spending. Retailers are in choppy waters as well. Since posting huge back-to-back gains in early 1992, retail sales remain at a relatively high level--but they lack any upward momentum (chart). Consumers were buying in July: The Commerce Dept. revised July sales to show a healthy 1% gain, twice the 0.5% increase first reported. But then shoppers stayed home in August, when retail buying fell back by 0.5%.

Merchants of durable goods were especially hard-pressed to keep busy. Sales of big-ticket items fell a steep 1.6% in August. Car dealers reported a 1.1% drop in activity last month, and the early reports on September buying don't look very good. Sales of domestically made new cars stood at a 6 million pace, little changed from the insipid 5.9 million rate in August.

The large 2.7% declines in both building materials and furniture are extremely ominous for the performance of the housing sector. Despite 30-year mortgage rates below 8%, home buying and construction haven't picked up as they must in order to keep this recovery going.

Like builders, manufacturers and retailers are anxiously waiting for consumers to show a pulse, because stay-at-home shoppers are curbing the recovery's strength this quarter. But to the economy's advantage later on, the weak pace of demand has taken the wind out of the sails of a once swiftly moving inflation rate.

Before it's here, it's on the Bloomberg Terminal.