For 1996, The Inflation Tiger Looks Like A Pussycat

Inflation this year has looked a lot like one of those inept rocket launches from the early 1960s. It tried to clear the pad, but it just didn't have the power. And for 1996, inflation won't even attempt another liftoff.

That much seems clear from the nation's business economists, who gathered in San Francisco on Sept. 10-13 for the annual meeting of the National Association of Business Economists, during which a panel of 49 forecasters offered the first comprehensive look at what to expect next year.

The NABE forecasters don't look for the economy to soar in the coming year, a key factor in keeping inflation down, but they don't expect it to crash and burn in recession, either. They see a modest growth rate close to the economy's long-term trend of about 2.5%, which is consistent with stable inflation.

The details: Consumer spending will grow moderately, in line with real gross domestic product. Stronger housing and a narrower trade gap will also add to growth, after subtracting this year. The pace of business investment will slip to single digits for the first time since 1992. And slow inventory building will be a drag on growth.

As for policy, the economists expect only modest deficit reduction for fiscal 1996, totaling some $13 billion, relative to what current policy would yield. And they believe that the Federal Reserve will be steady as she goes. As a result, they see short-term interest rates fairly stable at current levels, and the projection for long-term rates reflects that stability.

BUT THEIR INFLATION FORECAST is where the business economists seem most confident. They expect the consumer price index to increase 3.2% next year, about the same as the 3% pace anticipated for all of 1995. Federal Reserve Bank of San Francisco President Robert T. Parry, a noted inflation hawk, sounded even more sanguine when he told the audience, "I expect inflation to dip below 3% in 1996."

Inflation optimists have every reason to feel upbeat. Most recently, the August producer price index for finished goods fell 0.1% from July, and excluding energy and food, the core index rose a mere 0.1%. After accelerating earlier in the year, PPI inflation has fallen back to 1.3%. That's lower than a year ago.

And if you were worried that accelerating prices for intermediate goods would work their way forward to finished products, you can rest easy. The earlier runup in intermediate goods inflation had little, if any, impact, and prices at earlier production stages are now slowing. Prices of intermediate goods have not risen for two months, and prices of crude materials have declined in three of the past four months.

The glowing PPI report on Sept. 12 fueled strong rallies in both the stock and bond markets. The yield on the benchmark 30-year Treasury bond dipped to 6.5%, the lowest since early July, and the major stock indexes climbed to record highs. The excellent price performance holds open the chance for another interest-rate cut at the Fed's Sept. 26 policy meeting.

AUGUST RETAIL PRICES only reinforced the markets' optimism. The consumer price index rose only 0.1% in August, with the core index up only 0.2%. Prices of consumer goods were unchanged for the third month in a row, and service prices rose a slim 0.2% for the second consecutive month. Annual consumer inflation, running at 2.6% in August, seems likely to end the year very close to the NABE's 3.1% projection.

In fact, inflation is giving every signal that it has peaked for this phase of the business cycle, and that in 1996 it might well come in below its 1995 rate. The chief reason is the Federal Reserve's success at slowing the economy. That slowdown has resulted in an apparent peak in the rate at which the economy uses its production capacity and its labor.

As a result, the gap between actual and potential GDP, a measure of price pressures in the economy, reopened this year. Strong growth in 1994 had closed the gap, raising inflation concerns. This gap will appear even larger when the Commerce Dept. shifts to its new measure of gross domestic product in December, since the new numbers will show significantly less growth.

As the NABE points out, new fiscal restraint and a likely softness in oil prices are also inflation pluses. The current increase in worldwide demand for oil can be met by non-OPEC producers, so OPEC has no leeway to raise prices without losing market share. And deficit reduction will take stimulus out of the economy.

And don't forget, the CPI itself is overstated: It omits how consumers substitute cheaper items over time. It overlooks new products. And it misses quality improvements. The NABE says when the government re-benchmarks the CPI in 1998, inflation will end up 0.5 to 1 percentage point lower than the current measure.

But probably the most compelling reason for expecting lower inflation in 1996 is the recent strong growth of productivity and what that means for unit labor costs. As it turns out, productivity, measured as output per hour worked in the nonfarm sector, increased at the sterling annual rate of 4.8% in the second quarter, the largest increase in nine years. The Labor Dept. revised last quarter's reading up sharply from the already healthy 3% advance first reported.

AS A RESULT, UNIT LABOR COSTS last quarter were no higher than they were a year ago. That's the first four-quarter period of zero growth in 30 years. Unit labor costs are wages and benefits adjusted for productivity, and they act as a floor under inflation, because labor is two-thirds of a product's price. If they are slowing, inflation has room to slow, too.

Although the December GDP revisions will result in lower productivity growth than under current measures, unit labor costs may not be affected proportionately. Some analysts believe that compensation will be revised somewhat lower as well. So the performance of unit costs should remain excellent.

That showing sets this inflation cycle apart from all others. By this time in past expansions--those that lasted 4 1/2 years--the annual pace of unit labor costs had accelerated, as had inflation. By this time in the 1980s upturn, annual unit costs were growing 4.1%. The only time unit labor costs rivaled their current performance was in the early '60s--when inflation was about 1%.

What could knock the 1996 inflation forecast askew? Keep an eye on service prices. Despite the stellar outlook for goods inflation, service prices are half of the CPI, and service inflation has risen to 3.4% in August, from 2.9% for all of 1994. Although there is plenty of anecdotal evidence to the contrary, measured productivity gains in services have not matched those in manufacturing, so unit labor costs are growing faster.

However, that could be just a measurement problem, since gauging the output of a bank or an accounting firm isn't easy. If so, just like one of those old Vanguard missiles, the recent pickup in service inflation is likely to fall back to earth as well.

Before it's here, it's on the Bloomberg Terminal.