No wonder economics is called the dismal science. Just when prospects for growth in the second half look better, a few economists are now wringing their hands over the growing danger of inflation--and efforts by the Federal Reserve to preempt it. Already, bond yields are up sharply since mid-March, as investors demand a higher premium for possible inflation losses.
But let's not get too far ahead of the game. There's much to argue against inflation taking root anytime soon. First, although lower interest rates and tax cuts should buoy consumer demand, business-sector cutbacks in capital spending and labor costs will prevent a booming recovery that could boost companies' pricing power. Second, although productivity growth is tanking, as revised first-quarter data show, it should pick up as the economy recovers, and the current upward pressure on unit labor costs will ease.
Third, inflation lags the business cycle. By autumn, the economy will have grown only 1% for an entire year, far below its sustainable rate. That means there will be plenty of slack in the industrial sector to prevent prices from spiraling up. Inflation may well be peaking right now.
All this is why Fed Chairman Alan Greenspan remains sanguine about the inflation outlook. It's also why further cuts in interest rates, if only as recovery insurance, are still a good bet. Nevertheless, some Fed policymakers appear to be getting antsy about all the stimulus already in the pipeline, and the next cut may well be only a quarter point. That's especially likely since the May employment report, with its assortment of revisions to old data, shows that job growth so far this year is not as weak as the past data had suggested (table).
MAKE NO MISTAKE, though, the economy and the labor markets are still very soft. Nonfarm payrolls declined in April and May, and manufacturing job losses are getting progressively larger. Moreover, the dip in the unemployment rate, to 4.4% from 4.5% in April, is a data fluke, not a change in the trend. Joblessness is sure to rise in coming months, consistent with the increase in unemployment-insurance claims.
The lower May jobless rate, which is based on the Labor Dept.'s survey of households, occurred in conjunction with declines in both employment and the labor force. That means many workers who lost their jobs simply left the labor force instead of looking for more work, in which case they would have been counted as unemployed. The biggest drop in the labor force was among teenagers, many of whom were clearly part-time workers, where the jobless rate fell sharply. Joblessness among full-time workers was unchanged.
Labor's more closely watched survey of businesses showed a small 19,000 dip in May payrolls, but it was the revisions to previous data that changed the tone of the labor situation. April payrolls dropped by 182,000 instead of the 223,000 first reported, and the original March decline of 53,000 was revised to show a gain of 59,000. The revisions were particularly striking in private services. Originally, job growth there from December to April was said to have been 179,000. Now, it is 247,000, and the sector added 57,000 workers in May.
THE REAL TROUBLE SPOT in the economy remains manufacturing, which shed 124,000 workers last month. That drop, plus a shrinkage in the workweek, suggests that factory production in May posted a sizable drop, led by output cuts in business equipment, especially computers and related high-tech products.
Indeed, new orders for capital equipment excluding commercial aircraft posted a third consecutive large decline in April, the largest three-month drop since the last recession (chart). Orders for tech gear alone plunged 10.3% in April. Producers of tech equipment are wrestling with a mountain of excess inventories as shipments have fallen off sharply. The news was equally bad from the latest purchasing managers' survey. The May composite index of output, orders, employment, inventories, and delivery speeds fell to 42.1%, from 43.2% in April, indicating that the manufacturing sector is still in a recession.
The service sector, however, is holding its own. And because the labor markets remain relatively tight, hourly and weekly earnings continue to grow at a healthy clip. Hourly pay, up 4.3% from the year before, and weekly earnings, up 4%, are both rising faster than inflation and are providing solid support for consumer spending and confidence. Indeed, May auto sales looked surprisingly strong, at an annual rate of 16.7 million, up from 16.5 million in April. The resilience of consumers argues for a stronger second-half economy.
WHAT HARRIES the inflation worrywarts, though, is that the job markets may not have loosened up enough by the second half to reduce the upward pressure on labor costs. That concern was on the mind of Fed Governor Laurence H. Meyer when he spoke in front of the New York Association for Business Economics on June 6. Echoing a concern he voiced a week earlier in Scotland, Meyer said: "We have to be concerned that as we ease to mitigate the risks of a persistent slowdown or recession, we do not at the same time create conditions that would lead to higher inflation as the expansion gathers momentum."
Meyer's warning suggests that upcoming Fed policy meetings may be more spirited than normal, especially since, in a June 4 speech, Greenspan said: "Inflation is not a significant problem at this moment." And the Fed's favorite measure of inflation, the personal consumption expenditure deflator, which is calculated differently than the consumer price index, bears that out. Even though the core CPI, which excludes food and energy, has been increasing lately, the PCE deflator grew at a low 1.7% over the 12 months ended in April, the same rate as a year earlier (chart).
But the fear is that future productivity may not pick up fast enough to offset rising pay growth in a labor market where the unemployment rate peaks at just over 5%. Bear in mind, though, that productivity is very cyclical. Businesses are reluctant to cut jobs when demand first weakens, so productivity--output per hour worked--tends to fall in a slowdown.
That's what occurred in the first quarter. Output growth slowed, work hours rose, and productivity fell at a 1.2% annual rate. And since compensation kept rising, unit labor costs soared by 6.3%, the biggest jump in a decade. It wasn't until April that businesses began large-scale layoffs. But output may be falling just as fast as jobs are, so productivity is likely to be weak again this quarter.
Come the second half, though, productivity should get a strong cyclical bounce as output picks up. That means the rise in compensation will not be inflationary, and bigger pay gains--plus the stimulus of lower interest rates and tax cuts--will fuel the recovery.
By James C. Cooper & Kathleen Madigan