The Pressures Are Rising, But Inflation Won't Start Boiling

If history is a guide, the U.S. inflation outlook has reached a crossroads. The economy is thriving, fueling rapid job growth. Unemployment is down to levels that usually signal tight labor markets and bigger pay increases. And because cyclical gains in service productivity have about played out, unit labor costs in that key sector are rising faster, squeezing profit margins, and fueling companies' desire to raise prices. Typically, the economy would be set to bounce down the bumpy road toward higher inflation.

Don't buckle your seat belt just yet. True, the four-year decline in inflation appears to be bottoming out (chart). But unlike this point in past business cycles, there remain as many forces holding prices down as there are trying to push them higher. The upshot: Look for only a slight pickup in inflation in the coming year.

Most important, although cyclical productivity gains are fading, evidence is mounting that output efficiency has been permanently enhanced by corporate restructuring and investment in new high-tech equipment. The effect is a lasting reduction in unit costs and a less inflation-prone economy.

Indeed, a BUSINESS WEEK analysis suggests that net U.S. investment is significantly higher than government measurements show. If so, the economy has more room to grow without generating inflation than the current readings on joblessness and capacity utilization suggest.

That much is crystal clear in manufacturing where, unlike services, productivity gains are translating into falling unit labor costs. That's why goods inflation is the least of the economy's worries, as the June producer price index indicates.

Finished goods prices were flat last month after edging lower in both April and May, as price declines for tobacco products, appliances, and drugs offset increases in energy, including a 1.5% jump in gasoline prices. Excluding energy and food, the core PPI dipped 0.1%. During the past year, finished-goods inflation is zero, and core inflation is barely positive at 0.6%.

The effect of low inflation in goods prices is also apparent in the consumer price index. The CPI rose 0.3% in June, and the core index also was up 0.3%, about as expected. Annual consumer inflation stands at 2.5%, but that combines a 1.6% rate for goods and a 3.2% pace for services.

June prices were generally well behaved for both goods and services, partly because of continued moderation in the costs of housing and medical care. Energy prices were up only 0.1%, but they will probably rise much faster in coming months, since the nearly $6-per-barrel increase in crude oil prices since March has not yet shown up in gasoline prices at the pump.

The tame June price indexes give the Federal Reserve some breathing room to decide on its next move on interest rates, but policymakers cannot ignore the data that suggest it is crunch time for holding back inflation. Key Fed officials are sympathetic to the enhanced-productivity argument, but strong labor markets in June will probably elicit at least a quarter-point hike in the federal funds rate at the Aug. 17 policy meeting.

Fed Chairman Alan Greenspan might offer some hints on the Fed's thinking when he goes to Capitol Hill on July 20 to deliver his semiannual report on monetary policy, including the Fed's latest forecasts for growth and inflation, along with its targets for money growth.

The financial markets are clamoring for another rate hike in the wake of the unexpectedly robust report on the June labor markets, a sign that the braking effect of past rate hikes is not yet evident.

Nonfarm payrolls jumped by 379,000 last month, for a total of just over 1 million new slots in the second quarter and 1.7 million so far this year (chart). And the jobless rate remained at a low 6%.

True, special factors boosted June payrolls. There were five weeks between the May and June surveys instead of the usual four. The Labor Dept.'s estimate of jobs created by new businesses was a large 132,000. An extended school year--to make up for time lost during the winter--kept many teachers on the job. And the big gain in service jobs was linked to increased tourism generated by the World Cup.

Nevertheless, jobs are growing at the fastest pace since 1987 and in the second quarter, total hours worked rose at a 6.5% annual rate, the largest increase in more than a decade. What the data are saying is that the cyclical gains in productivity are waning. After all, for the past three years businesses have been working their existing employees longer hours in order to produce more output.

Now, those productivity gains are pretty much exhausted, so companies are adding employees to meet demand. However, new labor is near the bottom of the learning curve, causing a temporary slowdown in output per hour worked.

Nowhere is that clearer than in services, which generate half of the economy's output and more than three-fourths of its jobs. Since early 1993, hours worked in the service sector have outpaced output (chart), which has pushed up the sector's total wage bill while cutting into productivity. The result: Unit labor costs for service industries appear to have surged last quarter.

Since companies have little room to raise prices, profit margins are probably taking it on the chin. For example, retailers' sales margins slipped in the first quarter. As a result, companies can either raise prices or cut back on hiring. But remember, these are the austere '90s. It's more likely that a slower pace of hiring will prevail.

In fact, the rise in employment so far this year has not lifted pay very sharply. The average hourly wage in the nonfarm sector slipped 1 cents, to $11.08, in June. Hours also fell, by 12 minutes, to 34.6 hours, causing a 0.7% drop in weekly pay. Still, because hiring was so great, personal income, and thus consumer spending, likely continued to grow last month.

Better growth in jobs and earnings appear to be the fuel for the recently explosive growth in consumer installment debt. Outstanding balances on auto loans and credit cards, for example, jumped $10.4 billion in May, and they have skyrocketed by $31.9 billion since February, the fastest three-month growth on record.

Factory workers have enjoyed bigger wage increases than their service colleagues. In the second quarter, factory pay was up 2.7% from a year ago, compared to the 2.5% advance for service workers (chart). But unlike the service sector, unit labor costs in manufacturing are still on the decline.

Moreover, two factors argue against any sustained upward pressure on wages or unit labor costs. First, the perception that more jobs are available will bring out those jobseekers who are now on the labor sidelines.

Indeed, the government reported that 526,000 people dropped out of the labor force last month, even as the adult population grew by 183,000. During the past 12 months, the labor force has edged up a mere 0.2%, while the working-age population has risen 1%. That just doesn't make sense. The split suggests that the low unemployment rate overstates the tightness of the labor markets.

More important, because more intensive and smarter use of technology is raising the long-term trend in productivity, workers hired now will be more efficient by yearend. That will take some pressure off unit labor costs.

But even with today's low inflation, it is clear that the U.S. economy is at a crucial point. The price pressures from demand and labor are set to clash with the forces of better productivity and foreign competition. The most likely result: a standoff, with only a small rise in inflation.

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