How Long Can This Last?

Strong growth with little unemployment and low inflation doesn't have to peter out. Here's why

Could it possibly get any better than this? For two years, the U.S. economy has soared ever higher, reaching starry strata last explored in the 1960s. Growth has accelerated to an average rate of 4%, from about 2% in 1995. Unemployment has eased from 5.7% to 4.9%, its lowest level since 1973. Profits after inflation have jumped 14% over the past year, even as real wages inched up for the first time since the mid-1980s.

At each step along the way, economic pessimists warned that the economy was about to tumble into a yawning chasm. The conventional wisdom was that the U.S. could not sustain growth in excess of 2% or 2.5% annually without triggering inflation. Indeed, some economists predicted that the Federal Reserve had already missed its chance to keep prices under control and that inflation could rise as high as 3.5% in 1997.

The Cassandras had it wrong. Despite the stronger growth, inflation actually has fallen since 1995. Consumer inflation, outside of food and energy, is running at an annual rate of 2.4%, down from 2.6% in 1996 and 3% in 1995. The Fed's Beige Book survey of regional economic conditions, released on May 7, found virtually no sign of accelerating inflation. And the stock market has become intoxicated by it all. Investors, after bracing for a slowdown induced by Federal Reserve rate hikes in March, have changed their minds. Increasingly, they are grasping the possibility of continuing expansion without inflation. Since Apr. 11, the Dow Jones industrial average has jumped 10.8%. Even after fresh interest-rate jitters caused a 140-point drop on May 7, the market has retaken the ground it lost in March and early April.

"BLOWING UP EVERYTHING." What's behind this unprecedented bounty? It boils down to this: After years of pounding on costs and revamping the way it does business, American industry is reaping improvements in productivity that--if they continue--could sustain this economic scenario for the foreseeable future. In the first quarter of 1997, output per worker rose at a rate of 2.0%, its fastest pace since the end of 1993. Excluding small businesses and financial services--for which data are less reliable--productivity growth is running at 2.4% (chart).

What makes these numbers especially impressive is that they come after six years of expansion, a point at which business historically has stretched machinery and labor to inefficient levels. This time around, the gains are sticking: Companies still are downsizing, outsourcing, and reengineering themselves. At the same time, they've finally learned how to make good use of information technology. They've gone to computer networks, speeding communications internally and forging electronic links with their customers.

Consider Owens Corning. The market for glass and insulation is flat, and the company can't raise prices. So it's spending $175 million to revamp its computer systems and link its 150 operating locations together. "This meant blowing up everything we had," says Michael Radcliff, chief information officer. It will be worth it if the system delivers the 10% annual boost to productivity he expects. The company is already racking up productivity improvements: In the first quarter, its earnings jumped 8% on just a 3% rise in sales.

With companies throughout U.S. industry doing the same things, the economy may very well have moved to a new plane--to where it can sustain growth rates of 3% or even higher without inflation. Put another way, the upshift in productivity means, remarkably, that rising profits, growing wages, and low inflation can coexist as they have not in the past 25 years.

Higher productivity also means that the economy may be capable of sustaining 5% unemployment rates or lower without triggering inflation. The 4.9% rate for April was actually accompanied by falling hourly wages, a far cry from the 1970s and 1980s. Back then, when unemployment fell below 6.5%, inflation took off. Now, James Medoff, a labor economist at Harvard University, argues that the jobless rate could go as low as 4.5% without dire consequences.

Rapid growth can bestow many blessings. We have already seen its power, for example, to bridge vast political divides. Federal budget talks were at a standstill until May 3, when fresh data from the Congressional Budget Office got things moving: Unexpectedly high tax receipts, it said, promised to increase federal revenues by $225 billion over five years. The economic gift helped White House and Republican negotiators seal a deal to balance the budget by 2002 (box).

How long can the good times roll? "What's to stop it?" answers John F. Welch, chief executive of General Electric Co. If companies really have mastered the art of improving productivity, there's no reason to expect the bad old days of slow growth and rising inflation to return any time soon. "The fundamentals are different, maybe, from any we've ever dealt with," says William L. Davis, the new chairman and CEO of R.R. Donnelley & Sons Co., which is squeezing productivity gains from its printing businesses. "We're settling into a sound, secure, strong period of economic growth."

Nirvana, of course, has its risks. Productivity gains lift the economy onto a faster growth track, but they don't eliminate the ups and downs of the business cycle. So despite the good news, it's entirely possible that the economy could slow significantly in the second half of 1997. Such a slowdown, expected by many economists, could stifle profits and push unemployment back up. Moreover, if the dollar continues to strengthen, export sales won't make up for slowing demand for U.S. goods at home.

GETTING A PAYBACK. Equally worrisome, growth could continue, but the productivity surge of the last couple of years could peter out. That might happen if employers can't find enough skilled workers to fill the information-intensive jobs that drive the economy now. The bidding for skilled workers could ignite wage inflation. Then, if current productivity gains prove ephemeral, the Federal Reserve will have a clear-cut case for raising interest rates to head off inflation.

Still, there's compelling evidence that productivity improvements will, in fact, continue. Why? The answer lies largely in the now-pervasive use of information technology throughout the economy. For years, economists had been disappointed that billions invested in computers and related gear had not yielded a productivity bonanza.

That so-called productivity paradox now seems to be over. Starting around 1995--when the Internet suddenly became big business--companies began diverting bigger chunks of their capital budgets into computers, software, and communications equipment. That's also when productivity growth started climbing, and inflation began heading downward, despite faster growth. "We will look back to this as a time when companies' investments in computing power and software started to pay off," says Charles A. Heimbold Jr., chief executive of Bristol-Myers Squibb Co. The drugmaker now gathers detailed information on how doctors prescribe drugs so its sales reps can be far more productive.

The growing spending on information technology can be taken as evidence that business is getting a payback on its investment. "If the return on computers is higher than on other investments," writes Federal Reserve economist Daniel Sichel in a forthcoming book, "then that firm would continue buying more hardware and software" and cut back on other investments. Conversely, if spending on computers lags, that's a sign that companies had little faith in the productivity benefits of information technology.

STREAMLINING. From 1986 to 1995, business spending on computers grew somewhat more slowly than spending on other types of capital goods (chart, page 34). Indeed, for roughly that period, Sichel and fellow Fed economist Stephen Oliner found that computers did relatively little for productivity. Since 1995, though, Corporate America has reversed the trend, increasing spending on info tech at twice the rate of other capital goods.

The big change is not in the computers themselves, but in how they're being used. With networks connecting anyone to anyone else, it's now easier to use computers to streamline all sorts of business processes--and create totally new ones, such as letting your customers order goods from your electronic catalog on a Web site. A new information system at Hughes Electronics Corp., for instance, lets engineers interact across the globe, reducing the time to build a satellite from about 30 months to 18. As a result, "we've been able to offer more payload at lower cost in a shorter time," says CEO C. Michael Armstrong. "That shows up on the bottom line."

POTATO SCANNERS. Computers, of course, are not the only capital goods that have a payoff. Consider what's happening at Omaha-based food conglomerate ConAgra Inc., where profits soared by 13% in its latest quarter despite a 2% drop in revenues. One reason: productivity improvements at its Lamb-Weston unit, a major supplier of frozen french fries for fast-food restaurants. The company just finished installing automated defect-removal systems in the last of its nine U.S. potato plants. Now scanners detect discolored spots in sliced potatoes as they zoom by on conveyors, and razors automatically chop out the defects--all work that used to be done by hand.

Appliance maker Whirlpool Corp. is also getting more productivity from new equipment and methods. The company saw earnings rise 21% in the first quarter, despite a 1% decline in revenues. One reason: a new factory in Tulsa where design improvements and manufacturing efficiency allow Whirlpool to crank out products quickly and in bigger volumes by using far fewer parts. "In today's world, productivity is the ante to get into the game," says Robert G. Thompson, Whirlpool's controller.

Such productivity gains are crucial to keeping the current cycle going. As long as productivity is on the upswing, employers will be able to pay higher wages without having to pass the costs on in price hikes. So far, it's working: Real hourly wages for production workers have been rising at an annual rate of 1.2%, about the rate of overall productivity growth. Wage gains have been bigger in high-tech industries such as software, computers, and communications--running at about 4%--but those are precisely the industries where the technology improvements and productivity gains are greatest.

No company has taken more of its own medicine than Cisco Systems Inc., the giant of networking equipment that has aggressively applied state-of-the-art technology to make its 80% annual growth rates feasible. Cisco now handles 70% of the support calls it receives without human intervention, via the Web. "Going to the Web saved us 1,000 staff positions," says CEO John T. Chambers. That's $125 million a year in savings.

ENOUGH TO RELAX? Sometimes, improved productivity has nothing to do with machines--high- or low-tech. Take the contract that American Airlines Inc.'s pilots approved on May 5. It has a 9% pay increase through August, 2001, plus stock options. But productivity improvements, such as loosening restrictions on the use of reserve pilots, will substantially offset the wage gains. "The pilots stepped up to some productivity issues that will be very helpful to us in the years ahead," says American President Donald J. Carty.

As long as productivity keeps rising and inflation remains under control, the danger of intervention from the Federal Reserve--despite strong growth and low unemployment--will recede. For now, it looks as though the Fed may not feel compelled to pile on another rate hike on May 20. Indeed, evidence from local labor markets--which Fed Chairman Alan Greenspan follows closely--suggests that the current level of unemployment may be acceptable. Recent data show that states with unemployment at 5% or above have seen little acceleration in manufacturing wages over the past year (chart, page 33).

That could be enough to persuade Greenspan to relax. Through the 1970s and 1980s, Fed chiefs wrestled with pernicious combinations of double-digit inflation, steep unemployment, and faltering profits. Americans grew accustomed to daily reports of grim economic tidings. Now, they're getting the hang of something quite different: An economy that's relentlessly upbeat. How long can this last? Certainly, past the next murky jobs number or one-day stock market slide. This has the makings of something real.