Higher Pay, Higher Inflation? Not Necessarily

How strong is this expansion? Robust enough to last the economic equivalent of the New York Marathon? Or is the economy already starting to feel pooped as it runs against the headwinds from higher interest rates?

Right now, the opinion that matters most is the one held by the Federal Reserve. And chances are the Fed will decide at its Nov. 15 policy meeting that the economy is running too fast for its own good. That means higher interest rates to try to keep the expansion from overheating, with more rate hikes likely to follow.

The October report from the labor markets certainly showed plenty of vigor, although it did contain signs that the pace of job growth was slowing. Likewise, the latest news on home buying, car sales, and consumer credit also suggests that consumers haven't lost their stride.

On the inflation front, the Fed is undoubtedly disturbed by last month's sharp pickup in hourly wages. That was easily the most worrisome feature of October's job report, especially since the unemployment rate dropped to 5.8% from 5.9% in September, a sign of increasing labor market tightness.

Average hourly earnings jumped 0.7% in October. Although there has been a tendency for the wage data to spike up at the beginning of a quarter, last month's surge was the largest in more than 4 1/2 years. And the yearly pace of wage growth ticked up to 2.9%, the fastest 12-month increase in three years (chart).

HOWEVER, the third-quarter data on productivity argue that the economy's solid pace is not pumping up inflationary pressures, since efficiency gains are offsetting some of the effect of rising wages on labor costs.

In fact, productivity gains continue to supply much of the growth in output during this upturn. In the third quarter, output per hour worked in the nonfarm sector grew at a 2.7% annual rate. Since the beginning of this expansion, productivity has grown at an annual rate of 2.1%, accounting for 70% of the increase in real gross domestic product.

More important though, efficiency gains are holding back the growth in unit labor costs, inflation's most basic fuel. Unit labor costs rose a scant 0.1% in the third quarter, and during the past year they are up a mere 0.9%. Unit costs in manufacturing dropped 3.8% from a year ago (chart).

But costs at the factory are not the issue. Services are what's responsible for the recent wage acceleration. Every broad service category from utilities to retailing to finance posted exceptionally large pay increases in October, while factory wage hikes remained modest.

The trend of faster-rising service pay is disturbing for the inflation outlook because service productivity has not matched that of factories, meaning that service wages flow more fully into service-sector labor costs.

THE STRENGTH of the October job report was undeniable. Nonfarm industries added 194,000 workers to their payrolls on top of upwardly revised gains of 248,000 in September and 290,000 in August. In addition, the Labor Dept. said that payroll growth through March, 1994, was 760,000 higher than originally reported. Recent data, though, show a clear pattern of slower job growth during the past four months.

But what likely caught the eyes of the Fed--the financial markets certainly zeroed in on it--were the broad signs of pep below the headline numbers for employment. In particular, the workweek for all industry surged to 34.9 hours in October, the longest in seven years (chart, page 24). And the factory workweek climbed to 42.1 hours, close to the record high hit back in April.

The longer workweek and the payroll gains mean that overall hours worked began the fourth quarter by leaping at an annual rate of 5.6% above the third-quarter level. The gain suggests that output of goods and services showed few signs of moderating as the final quarter got under way.

The month's job gains were fairly broad, led by manufacturing, services, and retail trade. Factory payrolls posted an especially sturdy 40,000 increase, one of the largest since manufacturing jobs began to turn up about this time last year. Moreover, the October factory gains were the broadest in six years.

The data mean that October industrial production rose solidly and that capacity utilization continued to increase--trends that the financial markets took as a warning of price pressures. The wage pickup combined with the large advance in hours worked means that average weekly earnings also rose strongly. That gain suggests that personal income posted a hearty increase last month that will help to keep consumers spending as the holiday shopping season nears.

Job and income gains are a key reason why many consumers remain undaunted by higher interest rates as they go house-hunting. Sales of new single-family homes rose 2.6% in September to an annual rate of 703,000, the highest level since March, which was the high for 1994.

Still, higher rates are taking a toll. Most of the strength in new-home sales in August and September came from unusually robust activity in the Northeast, while sales in other regions looked weaker. Home mortgage applications fell in late October to the lowest level in almost two years.

Home sales in September were below their pace of a year ago when bargain-basement mortgage rates caused a rush of buying. In addition, the number of homes still available for sale hit a four-year high in September--suggesting less homebuilding ahead.

HEADING INTO the fourth quarter, consumers are still shopping, but not with the speed they exhibited a year ago. A good example is car buying, which is not showing the same kick that it did previously. Sales of U.S.-made cars and light trucks climbed 3.1% in October to an annual rate of 13.1 million. Sales peaked in the first quarter of 1994 and have dropped in each subsequent quarter.

Consumers are supporting the demand for durable goods by relying more on borrowing. Installment credit jumped again in September, rising $10.6 billion. More telling was the huge upward revision to the August numbers. Credit rose by $15.2 billion, instead of the $11.2 billion that was first reported. Auto loans and revolving credit accounted for most of the increases in the past two months.

Installment debt now stands at 17.6% of disposable income, and more borrowing seems to be in the cards. The recent pattern of credit suggests that consumers may be inclined to use plastic for their holiday shopping. That means buying this quarter will rise faster than income growth. This spending surge could become a purge in the first quarter, however, when those Visa and MasterCard bills suddenly pop up in mailboxes.

In addition, if consumers become overextended, they will be more vulnerable to the impact of the Fed's rate hikes. And given the vibrancy of the October labor report, more hikes are clearly on the way.

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