Where's The Economy Heading? Look To The Labor Markets

Want a crash course in the outlook? Take a look at the two latest reports from the nation's labor markets. They say more about where the economy is headed than all the rest of the data combined.

The Labor Dept.'s October employment report and its third-quarter update on productivity point to modest-to-sluggish growth and low-to-declining inflation for the next few quarters. That means there is a good chance that the Federal Reserve will cut interest rates this winter, especially if credible deficit cuts are in hand.

The economy's somber tone will come mainly from consumers. Employment growth has slowed to half its 1994 pace, suggesting that slower income growth will limit the advance in spending. The correlation between job growth and spending gains is pretty tight (chart).

Households had also been adding rapidly to their debt. Consumers aren't choking yet, but slower job growth is clearly straining some households' ability to repay. Delinquencies, especially on mortgages and credit cards, are on the rise.

Financial strains may lie behind September's relatively small $5.4 billion rise in credit-card and other consumer installment debt. The increase was half the August gain and the smallest since February. Credit-card debt rose by the least since last December.

The good news for consumers is that while payrolls are expanding more slowly, they are still rising fast enough to keep the jobless rate down. It dipped to 5.5% in October from 5.6% in September.

With job markets that tight, wage growth is starting to show a little upward creep. And with strong productivity gains keeping inflation low, hourly earnings of production workers are now rising faster than inflation. That's a key reason consumers won't shut their wallets completely during the holidays, but you can bet they will demand rock-bottom prices.

AS ONE ECONOMIST PUT IT: The October job report reflects an expansion that has lost its youthful glow but is far from in need of a rest home. Payrolls increased by 116,000 last month, and the increase in September rosters was revised to a slim 50,000 after an originally reported gain of 121,000. For the past three months, payrolls have risen an average of 143,000 per month, far short of the 294,000 monthly rate in 1994.

The October gain would have been higher if not for the strike at Boeing Co., which caused employment in the aircraft industry to plunge by 28,000. As a result, employment in manufacturing dropped by 21,000, but excluding aircraft, factory jobs actually rose slightly. In fact, payroll gains were the broadest since February, as 50% of manufacturing industries added workers.

The strike also dragged down the factory workweek, from 41.7 hours in September to 41.5 hours in October, and it will likely cause October industrial production to look weaker than it should, as well.

As the manufacturing sector struggles to get back on its feet, one potential problem bears watching. Factory inventories rose 0.6% in September, much faster than the Commerce Dept. had assumed when it put together its third-quarter estimate of gross domestic product. That means inventory growth last quarter might have been excessive, making factory output vulnerable to cutbacks in the fourth quarter, especially if consumer demand slows, as the job numbers suggest.

Meanwhile, the service sector, where three-fourths of the jobs are, continues to look healthy. Service producers added 112,000 new employees in October, and they continue to account for nearly all of the payroll additions in recent months.

THE BEST NEWS from the labor markets, however, comes from productivity, or output per hour worked (chart). For nonfarm businesses, productivity rose at an annual rate of 2% last quarter, following a huge 4.9% advance in the second quarter. During the past year, productivity growth has accelerated to 3.4%, an exceptional feat more than 4 1/2 years into an expansion when output per hour typically slows down.

Manufacturing, despite its toils, continues to lead the way. Factory productivity rose an astonishing 6.2% last quarter, the largest quarterly advance in eight years. That jump reflected a 3% increase in output and a 3% drop in hours worked--mainly because of declines in payrolls. Factories refuse to let their productivity slip, even in the face of slower demand. That's great for profits, but workers may feel left out.

Because productivity growth is matching--and in some industries exceeding--wage gains, unit labor costs are barely growing. Such costs, which comprise most of the price of a product, rose 1.1% last quarter, but over the past year, they are up a mere 0.3%.

In manufacturing, unit labor costs have fallen 0.8% during the past year, and they have been declining steadily for three years. Looking forward, in this climate the inflation rate cannot rise--and it is more likely to fall.

WHAT HAS BEEN UNUSUAL in this expansion's efficiency spree is the absence of rising living standards to reward workers. Now, there are nascent indications that workers are beginning to reap the fruit of Corporate America's push to lift productivity.

With inflation low, and with the hourly pay of production workers growing a bit faster, real wages are starting to rise. During the past year, hourly earnings are up 3%, while annual inflation, measured by the consumer price index, is running at 2.5%, implying that real wages have risen about half a percent.

That's not a lot, but except for 1986, when crashing oil prices distorted the CPI, it is the largest increase in more than a decade, and a clear break from the past trend. Moreover, since the CPI clearly overstates the cost of living--by anywhere from 0.5% to 2% as several studies show--the boost to real earnings is even greater (chart).

For example, using the price index for consumer spending in the gross domestic product accounts, real wage gains of production workers look even more impressive--the largest increase in almost two decades. Many economists believe this price deflator is a better gauge of the cost of living, because it measures prices of what people actually buy instead of a fixed basket of items as in the CPI.

Rising real wages have caught the attention of Federal Reserve Chairman Alan Greenspan. While addressing the Concord Coalition, the budget watchdog group, on Nov. 2, Greenspan noted that job jitters have helped to waylay most worker demands for higher wages. But with the unemployment rate so low, that acquiescence, especially among skilled workers, cannot last for long, he said.

If productivity helps inflation remain on a downward track, workers can benefit from rising real wages and from a boost in their living standards. Such a lift, said Greenspan, "would be all to the good." That's why 1996 may feel more prosperous for a lot of consumers than does 1995, even though the economy should grow at about the same pace in both years.

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