U.S.: The Economy Is Still Hopping And Fed Watchers Are Getting Jumpy

They're buzzing about a rate hike, which seems increasingly likely

Here we go again. The hoopla surrounding Federal Reserve policy meetings had quieted down in recent months compared with last summer, when an interest-rate hike looked imminent. Well, the ballyhoo is back. A few Fed watchers are even predicting that the central bank will lift rates as early as the Mar. 25 powwow, and if not then, they say, the May 20 meeting looks like a lock. So will they hike, or won't they?

The renewed urgency in the policy discussion has arisen mainly because the economy has not slowed the way the Fed said last summer that it must in order to relieve pressure on wages and prices. In fact, one report after another suggests just the opposite, that the economy is gaining momentum at a time when it is already operating dangerously close to its noninflationary limits.

The latest sign of strength comes from the labor markets, which the Fed has been watching the most intently. Nonfarm payrolls surged by 339,000 in February, besting nearly all expectations, and job growth has clearly accelerated. Also, the jobless rate dipped 0.1%, to 5.3%, and the recent drop in initial unemployment claims strongly suggests that it will go lower in coming months (charts).

The rest of the report was strong as well, with hours worked rebounding robustly from January's weather-depressed levels, while wage growth continued to trend higher, especially in services.

DESPITE ALL THIS, a rate hike as early as Mar. 25 is not yet a slam dunk. The crucial missing ingredient is evidence that higher costs arising from tight labor markets are fueling excessive demand for goods and services beyond what producers can satisfy without being forced to hike prices.

For now, demand indicators, such as commodity prices, capacity utilization rates, and the time it takes companies to produce and deliver merchandise, do not suggest that producers are under any great strain. These indicators weigh heavily in the Fed's decision-making process, and until they start to show more emerging pressure on prices that could fuel future inflation, the Fed has time to wait and watch.

The May 20 meeting is an entirely different matter. The way the economy is shaping up, those demand pressures are likely to become more evident this spring. That's partly because consumers are on a roll, fueled by the most supportive set of spending fundamentals in years. Consumer outlays are on a track to grow 3% to 4% this quarter for the second quarter in a row, after last summer's lull.

In the first quarter, a reversal of the fourth quarter's sharp improvement in the trade deficit will subtract heavily from economic growth, but that will hide the fact that domestic demand continues to gain momentum. The chief difference between now and last summer, when the Fed was on the verge of hiking, is that the economy now appears less likely to slow.

THE FED'S PRIMARY CONCERN about the strength in the labor markets is that job growth is fueling the current round of consumer-led demand. True, the February rise in payrolls was overstated. Surprisingly good weather, following unusually severe weather in January, resulted in a 109,000 rise in construction payrolls, although the previous year's trend was only 25,000 per month. But even excluding construction, the three-month average of payroll gains has picked up sharply and broadly from the pace of last fall.

The most notable part of the February labor-market data was the rebound in hours worked. After January's weather-related plunge to 34.2 hours, from 34.8 hours in December, the average workweek soared last month to 35 hours, an 11-year high. Combined with fatter payrolls, overall work time jumped 2.7% in February, more than making up for January's 1.6% decline.

Manufacturing hours also jumped, implying that February industrial production rose strongly, and the output gain will boost capacity utilization. Output is now growing faster than new capacity is coming onstream, suggesting that this and other demand-side price pressures will intensify in coming months.

Another key implication of the February rise in work time is that first-quarter hours worked are on schedule to post an annual rate of increase of about 4% from the fourth quarter. That pace suggests two things: One, quarterly growth in real gross domestic product remained strong, since hours worked is highly correlated with the quarterly pattern in GDP growth. And two, first-quarter productivity was stagnant.

The latter consequence is especially important in the Fed's thinking. Already, the Labor Dept. has revised fourth-quarter productivity growth sharply lower, cutting the originally reported gain of 2.2% in half, to 1.1%. As a result, unit labor costs grew 2.5%, instead of the tamer 1.4% first thought. Late in an expansion, productivity gains are harder to achieve as labor markets tighten, making it easier for wage gains to boost unit labor costs, a key factor in pricing decisions.

MOREOVER, TIGHT LABOR MARKETS continue to fuel wage growth. Average hourly earnings of production workers grew only 0.2% in February, a fact that seemed to soothe Wall Street's concerns about the stronger aspects of the jobs report. However, the three-month average of wages is up 3.8% from the same three months a year ago, the fastest pace in 6 1/2 years, and service-sector pay growth is nearing 4%.

In fact, service wages are now growing a good deal faster than the 2.9% pace of nonenergy service prices for the first time in this expansion (chart). This pattern suggests emerging pressure on profit margins that could spur price hikes. Services will be a crucible for future pricing trends, since they are more labor-intensive. Also, service productivity gains are smaller than those in manufacturing, and service pricing is less restrained by the strong dollar and global competition.

Of course, any worry that the Fed may have about future inflation would become moot if the economy begins to cool off, but right now, there is no sign of that. By the end of February, the four-week average of initial claims for unemployment insurance, a leading indicator of the economy and the jobless rate, had fallen to an expansion low, indeed the lowest since 1989.


The current level of claims is historically consistent with an unemployment rate of 5% or less. In fact, the jobless rate would be there right now if labor-force growth in recent months had not surged above its trend. However, the labor force is now growing faster than the adult population, a situation that can't last.

The bottom line is that the economy is moving slowly but inexorably toward the set of demand and cost conditions that will force the Fed to hike rates. It may not be there by Mar. 25, but the economy and the Fed are on a collision course for the May 20 meeting.

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