U.S.: If The Economy Doesn't Cool It, Officer Greenspan May Step In

It's on "an unsustainable track," he says--and the same goes for stocks

Is this red-hot economy finally starting to cool off? September data suggest that companies have cut back on their hiring, manufacturers are gearing down their production, and consumers are making fewer trips to retail stores. But despite the recent data, it's too early to make the slowdown call just yet. That's important because robust growth and sizzling labor markets are starting to get the attention of Federal Reserve Chairman Alan Greenspan.

The case for the no-slowdown outlook is straightforward. Given that third-quarter demand--especially by consumers--was booming, output and employment are unlikely to slow for long. The demand strength isn't hard to figure. The supports under it are as strong as ever: The trends in job and income growth haven't changed much, and wealth-enhancing stock market gains, attractive long-term financing, and generally free-flowing credit add further lift. Moreover, the Fed has been willing to give these bubbly financial conditions a free hand.

That may be changing, however. Unlike his remarks in recent months, Chairman Greenspan sounded none too upbeat in his testimony before the House Budget Committee on Oct. 8. He suggested that the economy has been on an "unsustainable track." He also backed away from his previously stated views on a new era in productivity. With the unemployment rate nearing its downside limit, he was skeptical that productivity growth could relieve growing strains on labor markets that could push up wages and prices (charts).

AS IF THAT WASN'T BAD ENOUGH for Wall Street, the chairman also said that any expectation of further stock market gains at the pace of the past two years was clearly "unrealistic." The markets went south in a hurry. The bond market plunged out of fear of Fed interest-rate hikes, which pushed up bond yields, and stocks, of course, got hammered, although not as badly as you might have expected given the sharp bond sell-off.

Specifically, Greenspan warned that, short of a marked slowdown in demand or a degree of acceleration in productivity growth that appears unlikely to emerge, "the imbalance between the growth of labor demand and the expansion of potential labor supply of recent years must eventually erode the current state of inflation quiescence."

Greenspan appears to be concerned that demand growth will not slow appreciably in the second half. In fact, there is a good chance that consumer spending in the third quarter matched the first quarter's 5.3% surge, which was the fastest pace in more than four years. Even amid the drag from what looks like a sharp slowdown in inventory growth, real gross domestic product last quarter appears to have grown greater than 3%, based on data available so far.

Moreover, the third-quarter data tell an important story for the fourth. They show that even as last quarter's inventory growth slowed after the largest buildup in 13 years, manufacturing output sped up, growing more than 6%, from about 4% in the second quarter. That says that inventories last quarter were reduced by stronger demand, not by production cuts. It means that a better inventory balance and persistent demand pave the way for further gains in output and jobs in the fourth quarter.

THE LATEST SLOWDOWN NOISES came from the September employment report. Companies added 215,000 workers to their payrolls last month, after an increase of 40,000 in August. However, because the strike at United Parcel Service Inc. lopped 185,000 workers off of August rosters--and boosted September payrolls by that much--last month's increase fell more than 100,000 workers short of economists' expectations. The two-month gain was the smallest since early 1996.

However, Greenspan said that job growth in August and September did not slow enough to suggest a closing of the gap between the demand and supply of labor. Indeed, quarterly averages, which smooth out the monthly blips, show job growth of 213,000 per month last quarter, including a big jump in July. That pace is below the 237,000 average in the second quarter and 228,000 in the first, but not by much, and it's about the same as the monthly clip during 1996. Private-sector payrolls slowed, but not dramatically.

In fact, if jobs continue to grow at their third-quarter pace, the unemployment rate, at 4.9% in September, will fall even further. Consistent anecdotal evidence, along with the ongoing downtrend in new claims for jobless benefits through September, suggests that labor markets are getting tighter, not looser.

THE LABOR MARKETS DO SHOW a developing trend that could positively affect both profits and inflation during the rest of the year: Productivity growth continued to accelerate last quarter. But even here, Greenspan argued that the pace might not last and that the gains would probably do little to correct the growing imbalance between labor demand and supply.

The official productivity numbers are not due until November, but the Labor Dept.'s data through September show that hours worked in the nonfarm sector rose at an annual rate of 1.1%. If real gross domestic product grew 3% or better, as expected, growth in output per hour worked appears to have been in the neighborhood of 2%. That increase would lift productivity growth over the past year also to 2%--the fastest annual pace in five years. The quarterly gain in manufacturing efficiency, perhaps near 7%, was even more striking.

However, as Greenspan suggested, it still is not clear if this year's productivity pickup is permanent or just cyclical, the result of the economy's rapid GDP growth. In fact, much of the economy's behavior this year looks like the boom phase of a mini-business cycle: a demand surge led by consumer spending on big-ticket durable goods and housing, a speedup in capital spending on traditional machinery and structures, and an inventory buildup. There is a good chance that this cyclical strength will unwind in 1998, much like the 1995 slowdown that followed a robust 1994. If so, this year's strong productivity growth might wind down with it.


So far, wage growth has been on a rising trend, buoying consumers, but the acceleration has been generally manageable for companies, given the offset from productivity. Going forward, however, service pay is the area to keep an eye on heading into 1998 (chart). Services are not subject to the same international price pressures as goods, and amid such tight job markets, new service employees may lack the skills and productivity of those who were hired earlier.

Fundamentally, it has been the strong job market that has fueled this year's consumer-led surge in demand. And until the labor markets begin to loosen, demand is unlikely to lose much momentum for long--and neither is the economy. That outlook is a key reason why Greenspan is starting to sound cautious.