Hiring Is Hot. Will The Fed Clamp Down Hard?

The Federal Reserve appears to be only days away from its fourth tightening of monetary policy in as many months. And after back-to-back robust job reports, the shell-shocked financial markets now have a new question to sweat through: Will the Fed need to hike interest rates more than expected in order to cool off a hot economy?

The markets have generally interpreted the Fed's intention to shift policy from accommodative to neutral as a hike in the overnight federal funds rate from 3% to the 4%-to-41 2% range. But after seeing the Labor Dept.'s latest set of employment data, which belie the recently reported slowdown in first-quarter economic growth to 2.6%, the financial markets now worry that the economy's true growth trend is upwards of 4% and that neutral policy may not be tight enough.

Wall Street knows that the job market has been this expansion's steadiest beacon. And in April, companies beefed up their payrolls by a surprisingly large 267,000 workers, a gain that would have been at least 337,000 if not for 70,000 striking Teamsters, who are now back at work. The March surge, expected to be revised down, was instead put even higher, at 464,000, and the February gain was revised sharply upwards, to 278,000. That's more than a million new jobs, the fastest three-month growth in five years (chart).

As if confirming the bond market's worst fears of rapid growth and rising inflation, the April job data touched off the largest one-day bond sell-off since the Iraqi invasion of Kuwait in August, 1990. By May 9, the yield on the benchmark 30-year Treasury bond had soared to 7.65%, the highest since December, 1992.


The bond market appears to be begging for more aggressive action from the Fed. Indeed, the market's reaction to the Fed's rate hikes is far removed from past experience. On average, over three-month periods from 1977 to the present, a one percentage-point change in the federal-funds rate has led to only an 0.21 point change in the 30-year bond yield.

However, from early February to early May, the federal-funds rate rose 0.75 percentage points, while the bond yield surged 1.3 points (chart). Certainly, markets are now more volatile, but even if this historical relationship is off by a factor of three, yields should still be less than 7%, unless the bond market expects significantly more tightening.

The bond market may have allies in Washington. As the Fed's May 17 policy meeting approaches, an internal debate appears to be brewing over just how aggressive policy should be. According to a May 10 report in the Los Angeles Times, anti-inflation hawks at the Fed believe rate hikes are warranted as long as the jobless rate is below 6.5% and economic growth is greater than 2.5%.

The hawks also think that the federal-funds rate may have to rise to 5% or higher in the coming year. The jobless rate dipped to 6.4% in April, and economic growth has exceeded 2.5% in each of the past three quarters. Others, including Fed Chairman Alan Greenspan, believe in less rigid parameters.

Are the Fed hawks and the bond market right, or is this much ado about nothing? Despite the hefty job numbers, the latest flurry of concern about the inflation outlook still seems to be an overreaction.

First of all, the U.S. economy is not firing on all cylinders. Although its structural barriers to growth are clearly easing, the economy is still constrained by restrictive fiscal policy, defense cuts, corporate restructuring, import penetration, and debt burdens. Moreover, fierce foreign competition and faster productivity growth are curbing price pressures.


In particular, productivity gains appear to be lasting, not fleeting as they usually are in a recovery. That means the economy can grow faster than 2.5%, and the jobless rate can go below 6.5% without generating price pressures. Measured as output per hour worked, nonfarm productivity growth slowed to an annual rate of 0.5% in the first quarter, but that followed a 6.4% surge in the fourth quarter of 1993.

Looking at the trend, productivity is up 2.6% from a year ago, a stellar performance for the third year of an expansion. And during the first three years of the upturn, corporate efficiency has risen at a 2.5% annual rate. That pace is much faster than during the expansions following the 1973-74 and 1981-82 recessions, even though those recoveries were far stronger.

The resulting benefit for inflation is the modest pace of unit labor costs. These unit costs surged at a 5% pace last quarter. That was clearly overstated, though, because the 5.6% advance in hourly compensation was far out of line with the earlier-repmrted rise in Labor's own employment cost index. Unit labor costs are up a mere 0.8% from a year ago, the slowest annual pace in 10 years, suggesting that wage-push inflation simply has no fuel.

The impact of productivity gains on unit labor costs in manufacturing is especially striking. Yearly growth in factory efficiency stood at a stunning 6.6% last quarter, while unit labor costs were down 1.7% (chart).


Market phobias aside, what does the latest labor report say about the economy? There's no denying that the jobs and hours-worked data were robust, but wage growth remains modest. With productivity gains, bigger payrolls don't automatically mean surging labor costs.

One reason for tame wage pressures is that the demand for labor has been very uneven. The percent of companies adding jobs has averaged just 58% so far this year. In other expansions, the rate has hit 70%.

The biggest winners so far this year have been skilled workers. The unemployment rates for skilled employees--from managers to repairmen--are falling much faster than the rates for lesser-skilled workers. And since skilled labor is where productivity gains tend to be greater, any pay increases caused by tighter labor markets are being offset by more efficiency.

In April, the bulk of the jobs created were service slots that tend to be low-paid or part-time. Of the 184,000 new private-service jobs, 76% were in restaurants, temporary help, and health care. But because there is still some slack in the labor markets, wage growth remains low. Hourly nonfarm wages rose 3 , to $11.06. Over the past year, wages are up 2.7%, about the same moderate pace as in the 12 months before that.

In addition, many of the new service jobs usually do not carry benefits, thus reducing labor costs. Companies have also used longer hours to avoid hiring new workers, thereby cutting down on benefits. The factory workweek stayed at its record high of 42.2 hours in April. The overall nonfarm workweek was also unchanged at a lengthy 34.7 hours last month.

More people working does mean more cash for consumers to spend. The huge job gains in April, along with a 0.3% rise in weekly pay, to $383.78, suggest another good increase in wages and salaries. And the uptrend in income will lift consumer spending at a moderate pace this year.

Better cash flow is also making it easier for consumers to borrow. Installment credit jumped $7.4 billion in March. But because income is rising just as fast, debt outstanding stood at 16.4% of disposable earnings in the first quarter, way below its peak rate of 18.7% in '89 (chart). Credit growth may slow soon, especially since the spending boom in consumer durables is starting to taper off.

The bond market, though, has latched onto the idea that more jobs will mean a wage-driven flare-up in inflation. But what the markets seem to be forgetting is that employees are producing more with every hour worked. And the impressive gains in productivity are why growth is not the enemy.