The Economy Still Isn't Cool Enough For The Fed

After seeing the weak numbers in January's employment report on Feb. 3, people seem convinced the long-awaited economic slowdown is finally here. Even the ever-skeptical bond market reacted with unabashed bullishness, which pushed stocks sharply higher as well, on the belief that the Federal Reserve may be finished hiking interest rates.

The Clinton Administration also has a substantial investment in the notion. The White House economic forecast accompanying its fiscal 1996 budget projects growth will taper off, from 4% in 1994 to 2.4% in 1995, with only a slight pickup in consumer-price inflation, from 2.6% to 3.2%. More important, the Clinton team is saying that no more rate hikes are necessary to achieve these results.

Really? These folks had better take a closer look at last month's labor market data. The details of the report just don't support the surprisingly soft headline numbers. Yes, the economy is starting to cool down from its 4%-plus pace in the second half of 1994. But by how much? Most of the January data now available suggest that first-quarter growth remains on the north side of 3%, not below it as the Fed desires.

TO BE SURE, the first hints that past Fed tightening is taking hold are in the air. You can't completely dismiss January's modest 134,000 increase in company payrolls, the least in a year, or the jump in the jobless rate to 5.7% from 5.4% in December. And that moderation comes on the heels of softer-looking retail sales, three quarters of gargantuan inventory growth, and weaker home buying--not to mention the largest plunge in new construction contracts in three years (chart).

The value of new building contracts dropped 8% in December, with homebuilding, business construction, and public-works projects all down. Homebuilding suffered the most, as sales of new single-family homes fell 0.6% in December, despite warm weather, and the month's supply of new homes for sale is now the highest in about four years.

But so far, these straws in the wind are hardly proof of a broad slowdown, especially since other labor-market indicators show no change in their recent trends. New jobless claims at the end of January were no higher than their fourth-quarter average, and the Conference Board's index of help-wanted ads jumped 3% in December to a 31/2-year high. Both measures are dependable forward-looking gauges that suggest labor-market strength, not weakness.

The most compelling sign that the job markets still had plenty of pizzazz last month is the jump in hours worked, an amalgam of total employment and the workweek. Since the workweek jumped sharply from 34.6 hours in December to 34.9 hours--matching October's 71/2-year high--total hours rose a sturdy 1%, implying a 4.2% increase at an annual rate from the fourth-quarter average (chart). Even if hours fall back in February, the figures still suggest economic growth of better than 3%.

Moreover, average hourly earnings rose 0.6% in January. That's a sizable increase. Together with the surge in hours worked it implies that personal income posted another strong advance last month. Consumers' buying power already has plenty of momentum. Real aftertax earnings had jumped 7.4% at an annual rate in the fourth quarter, far ahead of the 4.6% advance in spending. That's strong support for first-quarter outlays.

Borrowing--just where you would expect to see the results of Fed tightening--is speeding up. Bank loans in the first four weeks of January soared $32 billion. Commercial and industrial loans, an indicator of inventory investment, accounted for about half the increase, suggesting that businesses are still laying in new stockpiles at a rapid clip. Personal loans have slacked off a bit, but consumer installment debt still rose a hefty $7.4 billion in December, down from November's mammoth $12.2 billion increase.

A LOT OF CHURNING in the payroll numbers in recent months has distorted the true trend. Retailers added only 12,000 workers in January, but they had put on 81,000 in December and 132,000 in November--a holiday-influenced result. Also, government employment fell in both December and January after a sharp increase in November, reflecting temporary election workers and the January layoffs of temporary postal employees.

On balance, payroll gains during the past three months have averaged 293,000 per month. That's actually faster than the 241,000 per month in the previous three months. And despite the small January job increase, the percentage of industries adding workers actually increased from 59.4% in December to 60.5%, implying that the month's job weakness was narrowly based. All this suggests that February payrolls will rise strongly, or that the January job count will be revised upward.

Manufacturing payrolls are actually gaining steam. Factories added 39,000 jobs in January. The three-month average of payroll increases has been accelerating since last year. Indeed, factory overtime rose to a postwar record of 4.9 hours.

That makes sense. Factory orders ended the year with two strong gains, and the backlog of unfilled orders has risen sharply since August. These trends mean that industrial output in January, to be reported on Feb. 15, scored another solid gain, pushing the capacity utilization rate up from December's 15-year high. As long as operating rates continue to rise, the Fed will remain uneasy about future inflation.

JANUARY'S BIG WAGE increase is sure to catch the Fed's eye. Of course, the monthly earnings numbers bounce around a lot, but looking over the past six months, wage growth has sped up to an annual rate of 3.8%, up from only 1.6% in the previous six months. For half-yearly periods, it's the fastest pace in 41/2 years. That's a bad sign, especially since the economy is now entering the stage of an expansion when productivity growth begins to slow. The result is upward pressure on inflation's most basic fuel--unit labor costs.

Nonfarm productivity, measured as output per hour, rose 1.8% in the fourth quarter, about half the third-quarter pace. Looking at the trend, yearly productivity growth fell to 1.4% in the fourth quarter after peaking at 3% in the first quarter. That dropoff is the consequence of adding 3.5 million new jobs last year.

As a result, the yearly pace of unit labor costs picked up, to 2% last quarter after almost no growth during the year ended in the first quarter (chart). So far, the pace of unit costs remains slightly below the rate of inflation, but any further acceleration will start to push up prices or squeeze profit margins.

So until the Fed gets more concrete evidence that the slowdown is broadening, the risk of more rate hikes this year remains. Remember, the Fed never makes policy based on its, or anyone else's, forecast. When Fed Chairman Alan Greenspan said he would prefer policy to err on the side of restraint, he was saying the Fed will need proof that growth is slowing to a noninflationary pace. The January employment report just doesn't fill that bill.

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