Labor Markets Simmer, But Inflation Keeps Cool

Big Steel wants a 10% price increase. Chrysler Corp. is marking up the stickers on its minivans by 9%. Even a double tall cappuccino at the local coffee bars is getting pricier. Sounds as if U.S. inflation is bottoming out and has nowhere to go but up, right?

Not so fast. To be sure, it's that time in the business cycle when rising demand and costs start to push up prices. The strong July employment report and another hefty hike in consumer debt in June were the latest signs of that. A little upward creep in inflation, from about 2.5% currently, seems likely during the coming year, if only because this year's 40% jump in oil prices will lift energy costs.

But this time, the inflation outlook depends heavily on the factors that separate this expansion from previous ones. To begin with, the Federal Reserve began an early tightening of monetary policy while inflation was still falling in an attempt to slow demand--something it hasn't done since the 1950s.

And as for business costs, better productivity growth is keeping unit labor costs under wraps, even though wage growth is beginning to edge up. The result: Inflation may break above 3% next year, but not by much.

With the Fed on the case against excessive demand, it's the cost side of the inflation equation that bears a close watch--especially labor costs. On that front, the Labor Dept.'s July employment report shows another month of strong job gains and a low unemployment rate, generally seen as harbingers of wage pressures.

Businesses added 259,000 workers to their payrolls in July, on the heels of an even larger 356,000 jump in June. So far this year, new hires total almost 2 million, the largest seven-month gain in 61/2 years, and the advance has been broad (table). The jobless rate did tick up to 6.1% in July, but that's not statistically different from June's low 6%.

Those numbers clearly describe a strong labor market. But are they inflationary? Only days after the employment data came out, Labor published a much less ballyhooed report on productivity and costs that answered: maybe not.

Although productivity, measured as output per hour worked, fell at an annual rate of 1.2% in the second quarter, the trend over the past year shows that productivity continues to grow at a healthy 2.6% clip.

The result is the slowest pace of unit labor costs compared with any similar period of expansion in the postwar era. Unit labor costs, which consider the effect of productivity on wages and benefits, rose at an annual rate of 2% last quarter. But in the past year, unit costs are up a scant 0.4% (chart).

That's hardly a harbinger of inflation. Even though prices are up only 2.5%, almost no growth in unit labor costs means that profit margins have risen during the past year. Sure, there are scattered signs of improved pricing power--in steel and cars, for example--but fatter margins in an improving economy explain why second-quarter profits looked so strong.

All this is true in spades in manufacturing. Factory productivity rose at an annual rate of 3.8% last quarter, while unit labor costs dropped 5.2%. For the year, efficiency is up 5.2%, with unit costs down 2.6%. Clearly, factories are feeling no pain or pressure to raise prices.

Any problem from cost pressures is most likely to come from services, where productivity gains are slowing. That's because a variety of service industries have accounted for a big chunk of this year's acceleration in hiring, while output has not kept pace. Service-producing businesses added 231,000 workers in July, on top of the 311,000 put on in June.

But if the economy is slowing, as much of the recent data suggest, a cooler pace of demand will starve any cost pressures before they can build. So the pace of hiring seems likely to slow in the second half as businesses that can't raise prices act to avoid a squeeze on profits.

Despite the general strength in the July job report, one key labor-market indicator suggested that third-quarter economic growth was off to a tepid start: overall hours worked, which combine the month's big payroll gains with the unchanged workweek, at 34.6 hours.

Although total hours were up from June, they began this quarter with a rise of only 1.7% at an annual rate, after jumping 6.5% in the second quarter. Hours worked in manufacturing began the third quarter below last quarter's level, a sign that factory output is off to a weak start.

That likely reflects slow ordering by wholesalers and retailers, who are working down the extra inventories that had built up in the spring. Wholesalers managed to cut their stock levels by 0.4% in June, but paring down the pileup will take some time, because consumer spending is slowing down.

Indeed, consumers have become more cautious even as their take-home pay is on the rise. In July, nonfarm wages increased 0.4%, to $11.12 per hour, and weekly pay also advanced 0.4%, to $384.75.

Hourly wage growth is clearly trending higher (chart). In the year ended in July, wages had increased by 2.8%--better than the 2.3% pace in July, 1993. Moreover, wages are rising faster than inflation, something that has not happened since 1986. And better productivity growth is negating the inflationary impact of the wage uptick.

But if paychecks are growing, why the spending slowdown? One reason: The recent shopping spree satiated pent-up demand that had developed during the early, sluggish part of the recovery. Plus, consumers will probably shift some of their new income into savings, which have dropped to woefully low levels. Also, the new frugality of the '90s suggests that consumers will balk at goods they think are too expensive.

Of course, it isn't just income that is bankrolling all these trips to the mall. Consumers are borrowing a lot more in 1994. Installment credit soared by $10.9 billion in June. That was the fourth consecutive monthly increase above $10 billion--41% of which came from revolving debt, which includes credit cards. Borrowing was not that frenzied even in the debt-manic 1980s.

So far, the debt spree does not seem to be a strain on consumers. The ratio of debt outstanding to income edged back up to 17.2% in June--the highest reading in three years (chart). Still, it's below the peak of 18.6% hit in 1989. Consumers can probably add a bit more to debt loads before borrowing becomes a financial stress.

But even with the extra debt, the likely pace of job and income growth in the second half should support only about 21/2%-to-3% growth in consumer spending. And instead of paying a premium price for a morning hit of some exotic Kenyan blend, consumers might just opt for a cup of java from the local diner.

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