A Gathering Inflation Cloud
If you want to know what's happening in the U.S. economy, watch the mammoth services sector. So says economist William V. Sullivan Jr. of Morgan Stanley Dean Witter, who warns that Wall Street's preoccupation with retail sales and goods prices could lead many to misgauge the strength of business activity and inflationary pressures.
To be sure, the inflation yardsticks have rarely looked so promising. The producer price index declined 0.2% in November and was down 0.6% over the past 12 months. Import prices, which are not counted in the PPI, are running over 3% below their year-earlier level. Industrial commodity prices are hitting 40-month lows. And the consumer price index at last count was rising at an exceedingly modest 2.1% annual rate.
Although turmoil in Asia has helped on the price front, several domestic developments also appear favorable. As a result of revisions in capacity growth, for example, the Federal Reserve has just slashed its reading of capacity utilization in manufacturing from 83.3% to 81.7%--below the 83% threshold associated with past inflationary flare-ups. And the Commerce Dept. reports that retail sales fell in September and October, implying a slowdown in consumption.
The problem, claims Sullivan, is that focusing on such trends in the goods sector neglects the growing importance of services in the economy. Take consumption expenditures: From 1993 to 1996, outlays on services jumped from 56.1% to 58.3% of household spending, and at last count they were running at 59.1% (chart). "This rapid shift," says Sullivan, "means that retail sales are becoming a less reliable guide to the economy's momentum."
The 3% gap between the 1992 share and the latest reading, he notes, represents some $166 billion in added annual outlays allocated to services. Thus, just looking at the recent decline in retail sales misses the fact that growing services spending has kept overall consumption strong--rising at a 4.8% annual clip in September and October even as retail sales fell at a 2.4% rate.
The impact of service-related outlays on inflation is also growing, claims Sullivan. Service establishments don't have to worry about foreign competition, so they're much freer to respond to buoyant demand conditions and labor shortages by raising wages and lifting prices.
The warning signs are already apparent. Hourly wages of service-sector employees in November were up 4.5% over their year-earlier level, vs. 3.4% for factory workers. And the services component of the consumer price index is still rising at a 3% annual clip, compared with 1% for the goods component.