Profits Part Company With Paychecks

Weak economy. Strong profits. It's a combination that doesn't make sense. But in the first half of the year, the economy grew at an annual rate of only 1.6% while first-quarter earnings jumped 30% from a year ago, followed by a surprisingly healthy 19% advance in the second quarter. Last quarter's 0.5% growth in real gross domestic product was the slowest in 31/2 years.

How can this be? The answer is Corporate America's relentless pursuit of low costs and high productivity. That quest is clear from the tepid July performance of the job markets. And it is especially vivid in the last quarter's unexpectedly strong gain in productivity, measured as output per hour worked.

Even as second-quarter output barely rose, many businesses made big cutbacks in payrolls and hours worked, enough to result in a sharp 3% productivity hike. Indeed, the workweek shrank by the most in 15 years. As a result, unit labor costs rose a slim 0.6% last quarter. The trend shows how well businesses are managing costs (chart).

With unit labor costs up only 0.6% during the past year as well, and with prices generally rising about 3%, it's little wonder that many companies are able to make money hand over fist in even a sluggish economy. That pattern is especially true in manufacturing, where unit labor costs are actually falling.

For the second half, companies' cost-cutting zeal has two implications. First, inflation will continue to be a no-show in this expansion. And second, because businesses seem determined to keep hiring and hours worked on a short leash, economic growth will improve only modestly.

ALL THIS INCREASES the likelihood that the Federal Reserve has another interest-rate cut up its sleeve. The Fed next meets on Aug. 22 and again on Sept. 26, and given the more mixed performance of the economy recently, another quarter-point cut at one of those powwows seems like a good bet.

After a spate of solid economic news a few weeks ago, the third-quarter data so far look uninspiring. Reflecting continued cost-cutting, July job growth was frail, including a big drop in manufacturing employment. That means July industrial output was weak.

By the Fed's own Aug. 9 assessment of economic activity in July in each of its 12 districts, "most regions continue to report economic expansion, although in some areas, the rate of expansion has moderated recently." That moderation suggests more room for a rate cut.

The dollar's new muscle also gives the Fed more leeway to ease. Since hitting a postwar low of 80.63 Japanese yen in April, the dollar has risen 14%, to 91.60 on Aug. 9. During the same period, it is up 4% versus the German mark. Recent intervention by the Fed and the Bank of Japan has been successful in pushing the buck higher, but that's mainly because market forces already increasingly favor the dollar.

Moreover, the Fed also knows that first-half economic growth was even worse than the numbers now show. Based on the Commerce Dept.'s new chain-weighted GDP, which will become the standard for economic performance later this year, the economy grew at an annual rate of only 0.7% in the first half. And any third-quarter growth rate under the current GDP mea-

sure will show up smaller with the new numbers. Productivity growth will downshift a notch as well.

ONGOING EFFORTS to keep costs down and corporate profits up will continue to restrain demand in the second half. In addition, the inventory correction, which accounted for much of the second quarter's poor showing, will also be a drag on growth.

The inventory adjustment also played a part in the recent sluggish job growth. Nonfarm businesses added only 55,000 workers to their payrolls in July. And since March, monthly gains have averaged only 63,000, down sharply from 294,000 per month in 1994. The unemployment rate rose to 5.7%, from 5.6% in June.

However, July payrolls showed a sharp split (chart). Service-producing employment posted a healthy gain of 144,000, but manufacturers cut their payrolls by 85,000. That was the fourth consecutive drop in factory jobs and the largest in 31/2 years. The sharp decline suggests that manufacturers are still feeling the effects of businesses' efforts to wrestle their inventories into better alignment with demand.

Although the gain in service-sector jobs was respectable, increases in two seasonal, low-paying categories--restaurants and amusement parks--accounted for 40% of the rise. Moreover, the second-quarter productivity data show that services are also cutting costs and boosting efficiency.

Even amid the slack labor markets, hourly wages did pretty well in July. Nonfarm pay increased by a large 0.6%, to $11.49 an hour. And because the workweek rebounded from its weak second-quarter reading, rising by six minutes to 34.6 hours, weekly paychecks were up 0.9%, to $397.55. That gain suggests that personal income rose in July. Thanks to the tiny gains in unit labor costs, the economy can actually tolerate a bit faster wage growth without inflation worries.

Hourly wages grew 3.2% in the 12 months ended in July, up from 2.8% a year earlier. Even after adjusting for inflation, real wages are growing slightly.

THE RISE IN REAL WAGES, though small, means that consumer buying should continue to advance. The Johnson Redbook Report says that discount chains and department stores rang up 1.2% more sales in July than June. Sales then fell 0.9% in the first week of August, partly due to hot weather and Hurricane Erin. Sales of domestically made cars and light trucks, however, fell 6.1%, to an annual rate of 13.8 million last month. That drop suggests that auto makers may have to adjust their inventories further this quarter.

One startling consumer trend this year has been the surge in installment credit. Consumers took on $9.62 billion in debt in June, on top of a $13.1 billion gain in May. Revolving debt, which includes credit cards, rose by more than $6 billion for the fourth month in a row.

Retailers have not benefited from the borrowing binge. Over the past year, retail sales have grown by $10.8 billion, while revolving debt outstanding has mushroomed by $64.8 billion (chart). The gap reflects the expanded uses of credit, especially for services. Consumers can use plastic to pay for everything from college tuitions to airline tickets to medical fees.

Is all this borrowing signaling distress among consumers? Certainly, some households are mverextending themselves. But in general, the indicators of financial well-being, such as delinquency rates and debt-service levels, do not show any problems overall.

Absent financial stress, consumers are likely to maintain a healthy spending pace in the second half. That's crucial in keeping the expansion going, but as businesses keep an eagle eye on costs, job growth is unlikely to return to last year's pace. While that will hold demand growth in check, it will also bolster companies' bottom lines.

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