The Fed May Keep The Economy On Cruise Control

Policymakers at the Federal Reserve do not wander uninvited into one another's offices--it's considered bad form. But nowadays when they meet by chance in the hallways, the central bankers may well exchange some self-congratulatory small talk. After all, their desire for slower economic growth is panning out. And the latest price data show no threat from inflation.

Indeed, the U.S. may enjoy another year of having its cake and eating it too. Growth is slowing, but it's still strong enough to generate jobs. At the same time, inflation is barely cutting into buying power.

Of course, there are a few hazards in the outlook. The greater risk this year appears to be less growth rather than more growth. Although some regions will experience labor shortages, generally softer hiring in 1995 will reduce job-market pressures and temper union pay demands. So wage growth will remain modest (chart). And slower income growth will restrain consumer demand, still the key sector of this economy.

Another risk: Flagging consumer spending and the sudden drop-off in exports to Mexico have pushed up inventories sharply. Economists at Merrill Lynch & Co. estimate that inventories, as tallied in the real gross domestic product, grew by some $80 billion last quarter, perhaps the largest increase in postwar history. That means real GDP grew closer to 3% than 2%, but final demand was weak, setting the stage for output cuts--and slower growth--later on.

THE FED IS LIKELY to tolerate GDP growth from excess inventories because it is not inflationary. Moreover, other data suggest the Fed's 15-month strategy of hiking interest rates is succeeding. Nonfarm payrolls grew by 203,000 in March, far below the 286,000 pace in the previous six months, and consumer prices rose 0.2% in March, while producer prices were unchanged.

The March data, with their implications for weaker industrial output, income growth, and consumer spending, tilt the odds toward no action by the Fed at its next policy meeting on May 23. If so, that would be the first time since the Fed began hiking rates in February, 1994, that the central bank has held two consecutive meetings without raising rates.

Lurking in the background, however, is the imploding dollar. The Bank of Japan and the German Bundesbank continue to attempt to shore up the dollar against their respective currencies. And while the Fed will not raise rates solely to strengthen the U.S. currency, the central bank must be concerned about the inflation implications of a sagging dollar.

A weak currency lifts the prices of imports. And with foreign-made items commanding one-quarter of U.S. goods demand, a broad rise in import prices could have a significant impact on U.S. inflation. In February, the prices of nonpetroleum imports were up 4.4% from a year ago, a sharp acceleration from 1.8% in February, 1994. Monthly data go back only to 1990, but quarterly numbers suggest that import inflation is running at its fastest rate in more than six years.

BY CONTRAST, the overall consumer price index was up only 2.9% in the year ended in March. Excluding food and energy, the core CPI in March rose 0.3% from February and is up just 3% from a year ago.

Nearly all categories posted modest increases in March. Apparel prices were flat and are down from a year ago. Food prices were also tame, but the California floods may push up fruit and vegetable prices this spring. And medical costs remained moderate. Inflation for 1995 seems unlikely to exceed 3.5%.

The flat reading in the producer price index, after increases of 0.3% in each of the prior three months, is another sign that price pressures remain scant. Prices of food and energy fell last month, but even excluding those two components, the core PPI was up just 0.1%. In the first quarter, prices for both the total PPI and the core index were up by about 1.7% from a year ago.

Can such good behavior last? Probably. The only sign of growing pressure comes from intermediate materials and supplies used to make finished goods (chart). Intermediate goods prices rose 0.3% in March, with core prices up 0.4%, after 1% advances in January and February. The big price jumps have been in plastics, paperboard, and construction materials.

Over the past year, prices of core materials have risen 6.8%--far eclipsing the inflation pace of finished goods. But that's because few manufacturers have been able to pass along those steep markups. And if demand continues to moderate, they might not be able to do so in 1995, either, at least not in the U.S.

ONE OF THE KEY SIGNS for demand is job growth. Until now, the employment data did not signal much of an economic slowdown. The March report changes that.

In fact, the numbers show that job gains began to slow a year ago (chart). Businesses added an average of 239,000 jobs per month last quarter, way below the 309,000 in the fourth quarter. The jobless rate was basically flat last month, edging up to 5.5% from 5.4%.

Other tidbits in the report suggest that the slowdown is not a one-shot deal. Only 55.6% of industries added workers last month, the fewest in 11/2 years. The workweek was unchanged at 34.5 hours, while a fall in overtime led to a 12-minute drop in the factory week. Less work time usually precedes less hiring.

The mix of hiring also suggests job growth is slowing. Construction payrolls rose 58,000. But March's warm weather helped hiring in the building sector, so the increase probably won't be repeated in coming months. Manufacturing jobs fell 4,000 in March, and slots at temporary-help agencies declined by a large 35,000--the first drop in three years.

The declines in both factory jobs and hours suggest industrial production struggled in March. That weakness reflects the buildup in inventories in the first two months of last quarter. In January and February, inventories in manufacturing and wholesale trade grew by the fastest two-month pace in 101/2 years. Drawing down those stockpiles will keep future gains in industrial production--and jobs--to a minimum.

Slack job markets also dim the prospects for higher wages. The average nonfarm wage rose 0.3% in March, to $11.33 an hour. In the year ended in the first quarter, wages grew 2.6%, below the pace of inflation.

Of course, modest wage gains keep the inflation outlook bright. That's crucial because data on output growth and total hours worked in the economy suggest productivity rose very little last quarter. So improved productivity did not offset wage gains and temper unit labor costs.

However, without income growth, consumers cannot lift their spending. And household purchases remain the economy's major power. Balancing the forces of economic growth and inflation always has made the Fed's job tough. But right now, the central bank seems to have the right combination in place. That's why policymakers may just stand pat on policy for a while, keep their fingers crossed on the dollar, and watch how 1995 unfolds.

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