U.S.: Why The Fed May Tighten At The Speed Of A Tortoise

With inflationary pressures largely offset, expect slow and steady rate hikes

After three years of relentless uncertainty and downright pessimism over the outlook for business, company executives are facing a brand new problem: How to deal with a surging economy and the rising costs that come along with it. Materials are already more expensive. Inventories will have to be built up to meet new demand. And hiring costs will pick up as the labor markets tighten, especially given the growing pressure from benefits, driven mainly by health care. How companies cope with rising costs will be crucial to the outlooks for inflation and Federal Reserve policy.

The Fed is already thinking seriously about these issues. That's why policymakers changed their tune at their May 4 policy meeting. After more than a year of worrying more about falling prices than rising prices, the Fed now thinks the risks are equal, meaning that the threat of deflation is no longer an issue, and that the Fed's focus now is on maintaining price stability.

More important, policymakers began to set the stage for raising interest rates, perhaps by this summer. In the Fed's policy statement, it dropped the earlier wording about being "patient" before starting to lift rates. Instead, the Fed is focused less on when to begin tightening and more on how that tightening will proceed. The Fed said rates would likely rise at a "measured" pace, probably meaning a slow and steady clip dictated by the economic data. The statement was a clear signal to the bond-market players: Unwind any investment positions based on low rates now or suffer the consequences later, which could harm the economy.

Such a shift in the Fed's assessment of risks is a response to recent changes in the economic landscape. Real gross domestic product is growing at the fastest yearly pace in two decades. The percentage of industrial companies reporting slower delivery times is the highest in 25 years, while prices paid for supplies are rising rapidly. In the past, that combination would be a red flag for inflation and a rapid hike in interest rates.

But this is not your classic recovery. To be sure, some of the cost pressures developing follow the typical path of a robust economy. But key differences in this upturn will mitigate inflation's rise and the speed of Fed tightening.

FIRST IS THE IMPACT from world trade. Although the cheaper dollar is lifting import prices, global competition, especially from Asia, is more intense than ever. Meanwhile, China's officials are trying to cool down the nation's superheated domestic economy. That will benefit the U.S. inflation outlook. Commodity price hikes should ease; in fact, they are already off their recent highs. Plus, Chinese producers will try to make up for lost domestic sales by exporting more cheap products to the U.S.

Second is the fact that some of today's cost pressures may well prove to be temporary. The Fed's May 4 policy statement noted that long-term inflation expectations appear "well contained." Current price pressures may well be the result of a U.S. distribution system that is clogged by the sudden surge in demand.

Delivery Times Slow to a Crawl
For example, first-quarter real GDP grew at a 4.2% annual rate, below the consensus forecast of about 5%. But the shortfall can be traced to a smaller-than-expected gain in inventories. Real inventories barely grew over the past year, even as final demand shot up by 4.7%, the fastest clip since the go-go days of the late 1990s. That split suggests today's low inventory levels are not intentional. Instead, companies did not anticipate how strong demand would be and did not build up inventories fast enough.

AS A RESULT, many businesses are having difficulty getting the goods they need when they need them. The Institute for Supply Management reports that its index of delivery times hit 67.9% in March and 67.1% in April, indicating unusually long waits for goods to arrive (chart). The percentage of companies paying higher prices rose to 88% in April. These readings are the highest since the late 1970s, when the economy was beset by surging inflation.

But the situation back then was starkly different than it is today. Industrial capacity utilization was 87%; now it's 76.5% and rising only slowly. The late 1970s labor market was tight as a drum. Today's job situation is improving, but there is still considerable slack in the labor force. That's why the Fed still has some maneuvering room when it comes to hiking rates.

Of course, you would think that U.S. businesses would have begun to beef up their stockpiles to assure that they could handle the increased demand. However, according to the ISM, 30% of the companies they surveyed in April said that their customers' inventories were "too low." That's the highest percentage since the ISM began keeping records in 1996, and it suggests businesses must begin soon to restock their inventories rapidly.

The buildup in stockpiles will add significantly to real GDP growth in the second quarter and beyond. And as soon as inventories get better aligned with demand, delivery times should shorten considerably, reducing bottlenecks and the upward pressure on materials prices.

IN ADDITION, INVENTORY RESTOCKING should be a catalyst for better job growth, particularly in the factory sector. That will help to offset the restraint coming from another major cost, employee benefits. Already, the Fed's April Beige Book reported that companies in the Kansas City and Dallas Fed districts say that health-care costs are discouraging them from hiring new employees. For Fed policymakers, the question is whether the upward push in labor costs will translate into faster overall inflation.

So far, the answer is no. Total compensation paid by private industry increased by 3.9% in the year ended in the first quarter, about even with the 3.8% gain of a year earlier. Thanks to slack labor markets, businesses were able to hold down the growth in pay. Wages and salaries increased 2.6%, down from 3% a year ago. But benefits surged by 7%, the fastest rise in 14 years. Expenditures for medical insurance alone rose 9.3%, continuing a 2 1/2-year trend of increases of around 10% annually.

The Shift in Health-Care Costs
What interests the Fed is how companies are responding to keep these higher outlays from generating a classic wage-push inflation cycle. One line of attack is to shift more of the cost onto workers (table). For instance, from 1993 to 2003, health-care premiums paid by private employees rose by about 75%, according to the Labor Dept. For comparison, Labor notes medical prices rose by about 50% as measured in the consumer price index. And according to a recent survey, 10% of employers have already eliminated medical benefits for their retirees, and 20% said they plan to do so by 2007.

Most important, companies are covering these higher labor costs by increasing the efficiency of their workers. Productivity posted another solid advance in the first quarter, holding down unit labor costs and boosting profit margins. Wider margins will give businesses plenty of elbow room to absorb higher costs.

It's that kind of flexibility that makes this recovery different from those in the past. And that's a key reason why inflation pressures will remain muted and why the Fed will feel little urgency to jack up interest rates.

By James C. Cooper & Kathleen Madigan

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