U.S.: Why Cutting Unemployment Will Be One Tough Job

Companies are giving raises as productivity improves, but few are hiring

Forty thousand workers had a dismal start to the holiday season when their employers cut their jobs in November. Last month's increase in the unemployment rate to 6% ensured that 2002 will see the highest jobless rate since 1995. Will labor markets improve in 2003?

The question's importance extends beyond those looking for work or hoping to switch jobs. Consumer spending, the main engine of the recovery so far, will depend more on income growth in 2003 because households won't be able to tap other resources as they have this year. Given the recovery and the growing federal deficit, bond yields have about bottomed out, meaning fewer mortgage refinancings. And any tax cuts passed next year will probably target businesses, and not consumers who reaped extra buying power from the 2001 rebates and 2002 tax-rate reductions.

The job markets are also on the mind of Treasury Secretary nominee John W. Snow (page 30). At his debut press conference on Dec. 9, Snow said the Administration "cannot be satisfied until everyone--every single person who is unemployed and seeking a job--has an opportunity to work."

But the Secretary-to-be will face an unusual labor market next year. Given the paralysis among businesses, along with the continued pressure to boost profits, companies will remain reluctant to add much to payrolls (chart). At the same time, though, they will be willing to boost the pay and benefits of their existing employees because those workers have the expertise to keep productivity on the rise.

As a result, job growth early next year will probably average less than 100,000 a month, and the jobless rate will be slow to decline significantly. But real aftertax incomes should grow by about 3% next year, paving the way for steady gains in consumer spending.

THE NOVEMBER EMPLOYMENT REPORT, while disappointing, needs to be put in perspective. Total payrolls were higher last month than in April. Job losses remained concentrated in the slumping manufacturing sector; private-sector service companies in November added workers for the ninth straight month. And by historical standards, the 6% jobless rate is actually quite low at this stage of a recovery. A year after the 1990-91 recession, it was 7.4% and headed higher. After the 1981-82 downturn, it was a painful 8.5%. Moreover, the current readings on jobless claims suggest the rate will begin to fall at the start of 2003. In early December, the four-week moving average of claims, which eliminates the data's week-to-week jumpiness, is at the lowest level since the recession began (chart).

However, as Snow pointed out, any excess unemployment is undesirable, and a jobless rate hovering around 6% is high, given that real gross domestic product is growing at a 3.2% yearly rate. Back in 1994, the last time unemployment was 6%, real GDP was expanding by 4.1%. That suggests the economy can grow faster and more people can be put to work without any fear of price pressures down the road.

The lack of inflationary worries is the key to why the Federal Reserve will be able to keep interest rates very low next year. As expected, the Fed took no action at its Dec. 10 meeting. Policymakers kept the federal funds rate target at 1.25%. In the accompanying statement, the Fed said the risks for the economy were balanced between inflationary pressures and weaker economic growth. The Fed also noted that the latest available data, "taken together, are not inconsistent with the economy working its way through its current soft spot."

MORE BUSINESSES ALSO EXPECT brighter days ahead. The Institute for Supply Management released its semiannual survey of business expectations among its members. According to the report, 70% of manufacturers and service companies think their sales will be higher in 2003 than they were in 2002.

The ISM also said that manufacturers expect their capital expenditures to rise by an average of 4.6% next year, with service companies holding their capital budgets about flat. That's far from a boom, but keep in mind that factories and service companies will have cut this year's outlays by 6% and 2.6%, respectively.

But the outlook on jobs is cautious. Manufacturers see payrolls falling 0.6% next year, while the bigger service sector expects only a 0.2% gain. However, modest job growth and a jobless rate stuck between 5.5% and 6% does not mean wages will not rise next year. In fact, one of the twists in today's economic environment is that businesses may not be in the mood to hire, but they will be willing to pay their workers more in exchange for robust productivity gains.

GONE ARE THE DAYS of the late 1990s, when some employees enjoyed perks like dog walkers and huge signing bonuses. However, a survey of 852 midsize companies done by human resource company Compensation Resources Inc. found that companies will give bigger pay raises in 2003 to almost all employees. The exception is production workers, whose expected increase of 3.5% is a tad below 2002's 3.6% raise.

The survey also found that 43% of companies plan to give bonuses equal to or larger than the 2002 payouts. Those results match a similar report on big companies by the Conference Board, which noted that "most workers will still come out ahead of inflation," leading to future gains in consumer spending.

Companies will also pay more next year for their employees' health insurance. Mercer Human Resource Consulting LLC says businesses expect insurance costs to rise 14%. That's after medical coverage jumped almost 15% this year, to $5,646 per employee.

Of course, businesses need productivity increases to cover these higher compensation costs. This exchange was already evident this year. Hourly compensation rose 3.3% in the year ended in the third quarter, but output per hour worked jumped by 5.6%, so the cost of labor to produce each unit of output fell 2.2%. That's why profit margins in the third quarter were higher than they were a year earlier.

Expect that trend to narrow somewhat in 2003. But even if productivity is cut in half, that pace allows plenty of room to generate modest gains in both real wages for workers and profit margins for businesses, even if pricing power is weak. However, prices in the earlier stages of production are already firming up, and in the profits outlook, a little bit of pricing power goes a long way.

The bad news for job seekers is that productivity gains allow businesses to boost output without adding as many workers (chart). Executives will have to regain their confidence in the future before they begin hiring at a pace strong enough to significantly lower the jobless rate. And an improving profits outlook is one crucial part needed to restore that optimism.

By James C. Cooper & Kathleen Madigan

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