Despite All Odds, Growth Is Rising While Inflation Falls

The idea that inflation can slow as an expansion strengthens goes against economic wisdom. But before you say "Can't happen," consider other recent unexpected events: The PLO and Israel peace accord. The marriage of Julia Roberts and Lyle Lovett.

Theory notwithstanding, the downtrend in inflation highlights how this upturn continues to defy the rules written from the experience of past expansions. The incongruity is a result of the recession and slow growth of the past three years, which have left the economy with excess capacity and labor. This slack means growth can pick up momentum for a while without hitting up against production constraints or tight job markets.

To the economy's benefit, low inflation is giving consumers more buying power. It will also keep interest rates low in coming months. And cheap financing is enabling companies to invest more in new plants and equipment--a stellar source of growth over the past year.

There is a downside, though. The inability of businesses to raise their prices is a byproduct mf the modest uptrend of demand. And with pricing power nonexistent and with competition fierce, companies must continue to rely on cost-cutting in order to raise their profits.

So far this year, inflation's performance has been spectacular (chart). True, the consumer price index rose 0.3% in August, when only a 0.2% gain was expected. That rattled the bond market. The yield on a 30-year Treasury bond jumped from 5.87% to 5.97% on the Sept. 14 CPI news.

But the August blip is no sign of danger. For one thing, the major cause was a 0.9% jump in clothing prices, a result of the introduction of new fall and winter merchandise. The Labor Dept.'s adjustment process seems to miss the seasonal changeovers to higher-priced apparel lines. So prices may very well fall in September.

For another, prices elsewhere are dropping. Gasoline and heating-fuel prices fell in August, and tobacco products were cheaper too. Altogether, consumer prices are up just 2.8% from a year ago. Excluding food and energy, inflation is running at 3.2%. This core rate is likely to end the year below 3%, the lowest pace in 21 years.

Even medical care--the last bastion of huge price hikes--is seeing a steep slowdown in its inflation rate. Prices for health care rose only 0.2% in August. Medical care inflation has dropped from a peak of 9.6% in early 1991 to just 5.8% in the year ended in August.

Prospects are ripe for even lower inflation at the producer level. The producer price index for finished goods dropped an unexpected 0.6% in August, because of a 25.6% plunge in tobacco prices. But even excluding smoking products, the PPI was up a mild 0.2%.

Prices paid for finished goods have hardly budged over the past year, rising only 0.6%. And further up in the production process, the supplies and raw materials bought by businesses have increased by a mere 1%.

Moreover, the PPI measures only goods bought at the wholesale level. Prices for a range of services used by companies--including accounting, advertising, and legal services--are all negotiable as well.

The latest example of pricing flexibility: another round of airfare wars. After almost all U.S. carriers added $20 to round-trip fares in early September, Northwest Airlines Inc. offered deep discounts to drum up customers. Other airlines had to follow suit or risk losing business during the slow autumn travel period.

Improvement in inflation is likely to get a boost from the developments in the Mideast as well. Indeed, because of excess production by OPEC and weak demand globally, oil prices have fallen by 20% over the past year. The easing of tensions in the Mideast should allow prices to slip even further.

The August CPI data are likely to be a key topic of talk when policymakers at the Federal Reserve sit down for their next meeting on Sept. 21. Some Fed officials viewed the August rise as a disappointment. But the absence of any true price pressures--along with the desire to calm the bond market--suggests that the central bank will hold its policy steady.

That decision is also likely because the monetary bosses should see little need to give a boost to the economy. The latest data on retail sales suggest that consumers are still out shopping (chart). And the Commerce Dept.'s summer survey on plant and equipment spending shows that businesses are planning to invest more--not less--in the coming quarters.

Retail sales rose 0.2% in August, and the July gain was revised to 0.3%, up from 0.1%. Car-buying was strong, with a 0.7% advance last month. Building materials, food, clothing, and department-store goods also posted increases last month. After adjusting for prices, retail sales have risen 5.3% from a year ago.

The rise in retail sales suggests that business inventories continued to shrink in August, after a 0.5% fall in July (chart). Retail inventories declined 1.3%, led by a 4.9% drawdown of car dealers' stock levels.

After adjusting for price changes, store purchases have climbed steadily since their weather-related dip in March. And the initial news for September is encouraging. Sales of U.S.-made cars and light trucks stood at an annual rate of 11.5 million in early September, about the same as in August. And the Johnson-Redbook Report says that department-store sales in the first two weeks were up by 2% from August.

So far in the third quarter, real retail sales are growing at a 4.7% annual rate. That healthy pace hardly suggests an economy that is winding down.

In fact, the economy will continue to get a lift from business spending on plant and equipment. Already, outlays for capital equipment have accounted for one-third of the growth in this economy over the past year. And the surge in the production of business computers and accessories has boosted industrial output.

The Commerce Dept.'s survey of businesses taken in July and August shows that plant and equipment spending will increase by 7.1% this year, instead of the 6.4% advance that was reported in June. If it is carried out, the rise would be the strongest gain in capital investment in four years.

Companies plan the biggest increase for this quarter, followed by a smaller rise in the fourth. The funds will likely go for new equipment, especially machinery that raises the productivity of workers.

The emphasis on improving worker output is most acute at service producers. The Labor Dept.'s latest revision to the productivity data showed that nonfarm output per hour worked fell 1.3% in the second quarter. But manufacturers alone lifted productivity by a hefty 5.2%. It's not a surprise, then, that unit labor costs for all nonfarm businesses grew at a 2.8% annual rate last quarter, while factory unit costs slipped by 1.8%.

That split explains why services are leading the spending rush (chart). Service industries--including wholesale and retail trade, finance, and communications--plan to boost outlays by 10.6% this year. Manufacturers expect a 3.4% rise.

Of course, not all of the new money will be spent domestically. Foreign producers of machinery continue to make inroads into U.S. markets. That outside competition, though, will exert even more downward pressure on capital-goods prices, which rose only 1.8% in the year ended in August.

It is, however, forces like global competition, as well as rising productivity, that make the inflation outlook so bright--even as the economy gathers steam to grow at a healthy 3% rate. Inflation below 3% seemed impossible a few years ago. And who would have bet on mortgage rates at 6.5%? But just like the Israeli-Palestinian peace accord, sometimes the unexpected does happen.