U.S.: All This And Low Wage Pressures, Too

Productivity is up, unemployment down, and the Fed can bide its time

Just how tight are the labor markets? The unemployment rate would seem to say: "Very tight." In May, the rate edged up to 4.3%, just a notch above April's 29-year low of 4.2%. But this gauge does not tell the whole story. Other data hint that the labor markets may be looser than the rate suggests. In particular, superb productivity gains mean that companies can raise their output without adding workers. And most important, despite superlow joblessness, wages are growing more slowly.

For the rest of 1999, labor-market conditions will be critical to the future of consumer spending, inflation, corporate profits--and especially Federal Reserve policy. Modest gains in labor costs that can be offset by rising productivity will hold down inflation and keep the expansion going. In a low-cost environment, companies will be able to lift profits without raising prices. And in turn, tame inflation will expand household buying even if nominal pay raises grow smaller. That's important because consumers will be the linchpin of U.S. output growth this year.

Federal Reserve Chairman Alan Greenspan offered his explanation for the wage slowdown in a May 6 speech in Chicago. Greenspan believes low inflation has been a self-reinforcing process, because it has altered expectations: "Workers," he said, "no longer believe large gains in nominal wages are needed to reap respectable increases in real wages." He also pointed to productivity gains and continued job jitters.

GREENSPAN DID NOTE that the pool of available workers was shrinking and warned that "worker depletion constitutes a critical upside risk to the inflation outlook because it presumably cannot continue without eventually putting increasing pressure on labor markets and on costs." He admitted, however, that it cannot be judged "with precision" when the labor pool becomes so drained that wages and prices will rise.

And so far, that scenario is nowhere in the outlook. The April employment report showed that job growth was healthy in all sectors except manufacturing (chart) but that wage growth had slowed further. Total nonfarm jobs rose 234,000 last month, following an average of 186,000 in the first quarter. Manufacturing, however, let go of an additional 29,000 workers.

The problems in the factory sector, mostly related to weak exports and import competition, have retarded job growth tremendously. Total nonfarm payrolls rose 2.1% in the 12 months ended in April, down from a 2.6% pace a year earlier. But exclude manufacturing jobs, and payroll growth remains at a solid 3%.

The layoffs in manufacturing explain some of the slowdown in wage growth, but not all. Factory jobs tend to pay more than the average service wage, so the loss of those jobs holds down overall average pay gains. However, pay raises are also shrinking in the service sector, which hired 253,000 new workers last month.

In April, overall hourly pay rose just 0.2% for the third consecutive month, to $13.11. Wages are up just 3.2% over the past year, down from last April's 4.4% pace, which was the high for this expansion. Factory wage growth has slowed from 2.8% to 2.5%, while service pay increased 3.5%, a sharp deceleration from its 4.9% yearly gain in April, 1998.

GIVEN THE SOLID GROWTH in service jobs, it is remarkable that service companies are not bidding up wages faster. The explanation may be that, the low unemployment rate notwithstanding, the demand for labor across the entire economy may be easing and the supply is rising.

How so? First of all, the loss of 407,000 factory jobs during the past year creates a fresh supply of workers for the service sector. Second, the labor force is increasing at a faster rate. Yearly growth in the labor force had slowed to less than 1% by last summer, but the April pace was back up to 1.4%, which means about 77,000 additional people looking for work each month. The perception that jobs are easy to get may be encouraging more people to join the workforce. Immigrants are also expanding the labor pool, as is welfare reform.

Third, the average workweek has leveled off (chart). Companies in need of labor typically extend the hours of their existing workers to meet that demand. Since mid-1998, however, the workweek has stayed around 34.5 hours, down from an expansion high of 34.8 hours in January, 1998. Some of that decline reflects a half-hour cut in the manufacturing workweek, to 41.7 hours in April. But the service-sector workweek in April was the same 32.9 hours it was a year ago. If service companies needed production workers so badly, hours should be growing.

In an effort to hold down labor costs, though, companies are using more part-time and contingent workers to match labor demands more closely with changing output levels. That strategy not only lowers a business' total bill for wages and benefits but also boosts each worker's productivity. And productivity increases appear to be the main way many businesses are reducing their demand for workers.

AS GREENSPAN POINTED OUT, businesses are investing in more high-tech capital equipment in order to replace labor. Of course, this trend is not new. For years, automated teller machines have replaced bank tellers, computers have subbed for phone operators, and accounting software has cut the need for bookkeepers. But the continued boom in capital spending is a key reason why productivity has soared in line with the recent surge in domestic demand.

Output per hour worked in the nonfarm business sector grew at a stunning 4% annual rate in the first quarter, after a 4.3% advance in the fourth. The efficiency gain offset almost all of the growth in hourly compensation. As a result, unit labor costs rose at just a 0.3% annual pace last quarter, after falling 0.4% in the fourth (chart). For the year ended in the first quarter, nonfarm productivity was up an impressive 2.7%, while unit labor costs rose just 1.3%.

U.S.: All This and Low Wage Pressures, Too
U.S.: All This and Low Wage Pressures, Too
U.S.: All This and Low Wage Pressures, Too

The sharp slowdown in unit labor costs may partly explain why first-quarter profits perked up, after a disappointing showing in 1998. In addition, strong domestic demand last quarter brought in solid revenue gains. However, since pricing power remains weak, profits margins are still under pressure.

To shore up their bottom lines further, companies will continue to look for ways to increase productivity and cut the growth in unit labor costs. Greenspan may have warned that accelerating productivity "cannot have changed the law of supply and demand" in the labor markets, but for now at least, businesses seem to be bending the law. And if they succeed in holding down their labor costs and prices for the rest of this year, the Fed will be happy to sit tight in 1999.