U.S.: Will Greenspan See Inflation Clouds Gathering?

"Well, Senator, you know, I think that the current period--meaning the early weeks of the third quarter--is a very crucial period for this business cycle."

With those words to Senator Paul S. Sarbanes (D-Md.) during Chairman Alan Greenspan's semiannual report on monetary policy on July 18, the Federal Reserve chief put the markets on alert. He suggested strongly that the onus of an interest-rate hike rests with the upcoming economic data--all but saying that if the robust data doesn't settle down, we're gonna tighten.

Greenspan's testimony, which he repeated before a House subcommittee on July 23 without breaking new ground, was candid and unusually free of Fedspeak. He said that, while evidence of inflation pressures is scant, "there are early indications that this episode of favorable inflation developments, especially with regard to the labor markets, may be drawing to a close."

And even though the Fed is officially forecasting slower growth and reduced inflationary pressures in the second half and into 1997 (table), the chairman noted that any evidence of a slowdown was sorely lacking and that the process of slowing must become evident in the period immediately ahead.

That's why the Fed, which must act preemptively because policy works with a lag, has moved to a level of what Greenspan called "heightened surveillance." He said that the coming weeks "will tell us to a substantial extent how the economy is likely to evolve, not only for the rest of the year but well into 1997."

SO BETWEEN NOW AND AUG. 20, the date of the policymakers' next meeting, what will the Fed be looking at? Greenspan's testimony provided plenty of clues. A trio of upcoming economic reports will form the basis for any Fed action--or inaction. They will all be released within four days of each other, so the period from July 30 to Aug. 2 could be one of high volatility in the financial markets. Of course, there is no magic number that will push the Fed to move, but here's a general guide for what to look for in the data (table):

The Labor Dept.'s employment-cost index (ECI), due on July 30, will provide an important indication of wage pressures. Greenspan mentioned in his testimony that the first-quarter acceleration in the wage component of this index, to an annual rate of 4.6%, may be a sign that workers' willingness to surrender wage gains for job security may be lessening.

If the overall ECI for private-sector wages and benefits rises at a quarterly rate of 0.8% or more from the first quarter, and if the wage index does not settle down, then the Fed would read that data as evidence of emerging inflationary pressures. Right now, the median expectation among economists is 0.8%.

Wage pressures came to light in the monthly data in the June employment report. Greenspan, however, prefers the quarterly ECI measure of wages to the monthly numbers, since the ECI is not affected by the changing composition of employment. He noted that some of the recent pickup in monthly wages might be due simply to job shifts to higher-paying industries.

THE NEXT CRUCIAL ECONOMIC REPORT will come on Aug. 1 from the National Association of Purchasing Managers' reading on factory activity. Greenspan noted that perhaps the most important reason why the economy was not showing signs of slowing could be the desire of businesses to rebuild their inventories in the face of increasingly lean stockpiles. This would boost production and incomes heading into the second half.

Economists expect the NAPM's July index--a composite of orders, production, employment, inventories, and delivery times--to rise to 55%, up from 54.3% in June, suggesting accelerating activity. But the Fed will focus on two components of the report: the percentage of companies reporting slower delivery times and the portion paying higher prices for supplies.

The Fed chief said that mounting delivery delays in June raise warning flags that factory activity is picking up steam. If the NAPM's supplier-deliveries index rises to 55%, the third gain in a row, the Fed would view it as a sign that market slack is spent and that pricing pressures are rising. A confirming sign would be a rise in the NAPM's price index to 55%.

The most critical data, though, will come from the July employment report on Aug. 2. That will be the first broad reading of the economy in the second half. Where the Fed is concerned, job growth must slow from its first-half pace of 232,000 per month, because at that pace, the jobless rate will reach 5% by yearend, an inflationary level by any economist's reckoning.

Analysts don't expect much slowing, however. The current expectation for payrolls is a gain of 200,000. Any increase will get a temporary boost from the Olympic Games, but a gain of 220,000 or more would probably be too hot for the Fed's taste. The central bank is already getting uncomfortable with the current jobless rate of 5.3% amid faster rising wages.

Finally, if July hourly earnings rise 0.4% or more, then yearly wage growth will increase to 3.5%, the fastest pace in 6 1/2 years. Even a 0.3% gain would imply no slowdown from June's 3.4% pace. Given policymakers' growing concern with tight labor markets, a universally strong job report would make a prima facie case for a rate hike, maybe even before the Aug. 20 meeting.

THE FED WILL ALSO LOOK AT the second-quarter report on gross domestic product, due on Aug. 1. That reading is already widely expected to be strong--about 4% by current projections--so it's largely old news.

Still, there could be some forward-looking information in the mix of the components, especially between final demand and inventories. Overall demand appears to have held up well, led by consumer spending and housing. Labor market strength is offsetting the downdraft from higher long-term interest rates and debt.

But as Greenspan noted, the stronger dollar is exerting some anti-inflation pressures, as it holds down import prices and diverts some of that strong domestic demand toward imports. Indeed, nonoil import prices fell for the second month in a row in June, and rising imports widened the trade deficit in May, to $10.9 billion, up from $9.6 billion in April. The wider trade gap was a big drag on second-quarter GDP (chart).

Looking ahead, Greenspan also pointed out that foreign economies are starting to pick up. Exports, which hit a record in May, will rise further in the second half, adding more fuel to manufacturing.

For a data hound like Greenspan, the coming weeks will provide a flock of economic leads to sniff out. Judging by his testimony, he seems genuinely uncertain about where the economy is heading right now. But his words also strongly suggest that his instincts are telling him that the risks of future inflation are on the rise. Based on the recent trends in the data, the numbers due out over the next week or so are likely prove that his instincts are correct.