U.S.: Sobering Stats That Evaded the Radar

The employment cost index shows companies struggling to curb benefits

Investors, economy watchers, and the media spent a lot of time picking over the details of the dismal report on fourth-quarter gross domestic product. But they largely ignored a government report on labor costs that will have a far greater effect on the economy in 2003 than last quarter's growth rate.

True, the Commerce Dept.'s report that real GDP grew at only a 0.7% annual rate was not welcome news. Consumer spending slowed, as did inventory accumulation, while exports fell outright. The meager gain in output came from higher government expenditures, a small increase in business investment in equipment, and outlays for new housing.

The disappointing GDP report reignited talk of a double-dip recession, but the fourth-quarter slowdown was just another leg of the stop-go pattern that real GDP has exhibited since late 2001. When viewed on a yearly basis, the economy grew a healthy 2.8%. And the January readings on retailing, the industrial sector, and car sales suggest that growth is accelerating again in early 2003 (chart).

But since most economy-watchers were busy dissecting the GDP report immediately after its Jan. 30 release, they paid little notice to the simultaneous release of the Labor Dept.'s employment cost index (ECI), a quarterly accounting of what businesses shell out for wages, salaries, and benefits. Ignorance in this regard will not be bliss. The data show that companies are struggling to rein in their compensation costs, and rising expenses will be a continuing challenge for corporate cost-cutters in 2003.

THE EMPLOYMENT COST INDEX showed that total compensation in private industries rose 0.7% in the fourth quarter, or 3.2% for the whole year. That was the smallest rise in compensation in six years.

But the top-line number masked a sharp split between the wages and salary component and the benefits category. Wages and salaries rose 2.7% in 2002, the leanest pay raise in eight years. The slowdown was widespread among occupational groups, although health- care workers saw a severe drop in salary gains. Their pay raises shrank from 4.9% in 2001 to 3.5% in 2002.

While companies were able to hold the line on wage growth, they had less success on benefits. Company perquisites rose 4.7%, not much less than the 5.1% gain in 2001. And benefit costs will probably rise an additional 5% or so in 2003, given the trends in health-care costs, pension funding, and mandated benefits.

Right now, benefits account for nearly 30% of all compensation, and the fastest growing perk is health care (chart). Health insurance costs rose 10.2% in 2002. Although Labor cautions that its data on health benefits are not as reliable as the overall numbers on benefits since its survey sample is smaller, the health-cost rise in 2002 was the largest in 11 years. Worse still, Mercer Human Resource Consulting LLC reports that employers expect health-insurance costs to rise another 14% in 2003.

GROWTH WAS ALSO RAPID for pension costs. The stock market slide reduced the market value of existing pension funds. As a result, many companies must make greater contributions to replenish the money promised to existing and future retirees. Economists at Morgan Stanley estimate that the Standard & Poor's 500-stock index companies will have to come up with some $40 billion to cover their current pension shortfall, even if their 2003 investment returns average 5%.

Companies will also face larger bills for mandated benefits, which are included in the ECI. State governments, faced with a collective $25.7 billion budget shortfall this year, are raising fees paid by companies. In particular, rates on workmen's compensation and unemployment insurance have been hiked by some states.

Faced with a rising tab for perks, companies will look for other ways to save costs. The most obvious choice will be wages and salaries, but right now, surveys indicate salaries will rise, on average, between 3.5% and 4% in 2003. Keep in mind that, with the jobless rate at about 6%, the amount of slack in the labor markets is low by historical post-recession standards, and highly skilled, highly productive workers are still in demand.

Productivity gains will help both companies and workers. While such growth this year is sure to be slower than 2002's rapid rise, it should be solid enough to allow increases in both pay and profit margins. Plus, job growth should begin to pick up later this year, lifting overall personal income.

Even without job growth, household buying power ended 2002 on a strong note. Real aftertax income in the fourth quarter rose 5.9%, the fastest annual pace since 1984 (chart). Wages and salaries rose by 1.7%, recouping their dip in 2001 when the recession hit payrolls. But what largely boosted overall income was a drop in tax payments. Personal taxes and fees fell by 15.5% last year, with more cuts on the way. That will provide another lift to income growth, probably by the second half of this year.

UNTIL THEN, THE ECONOMY must create some momentum on its own so that companies can spread out some of their labor costs over a broader base of production and sales. The latest data offer cause for some cautious optimism on the industrial sector while also showing that consumer demand is holding up well.

The industrial activity index of the Institute for Supply Management stood at 53.9% in January. While that was down from December's 55.2% reading, the index was above 50%, a sign that manufacturing is beginning to mend. In fact, the ISM said the January level was consistent with 4% growth in real GDP.

The latest readings on demand and output were very encouraging. The new-orders index stood at 59.7%, just below the 62.9% in December. And export demand increased for the second month in a row, hitting a three-year high of 55.6%. The nation's purchasers said production grew in January, which suggests the Federal Reserve's reading on industrial production increased in January as well. The ISM's separate January survey of nonmanufacturers showed evidence of faster growth in that sector, too.

Consumer spending may show more muscle this quarter. January vehicle purchases totaled an annual rate of 16.2 million, not far below the 16.5 million pace of the fourth quarter. And weekly surveys of store sales in January show gains from December.

The extent to which consumers keep spending will depend mostly on their aftertax income growth. That's why the trends on wages, salaries, and benefits will play a leading role in the recovery's future. The good news is that pay raises are likely to stay at least modestly ahead of inflation. But until the recovery kicks into a higher gear, companies will struggle to balance how much they pay in wages against the amount they have to shell out for benefits.

By James C. Cooper & Kathleen Madigan

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