U.S.: This Time, Fed Tightening Shouldn't Make You Tense

With jobs strong and inflation low, the economy is in fine shape

It seems odd that just when the job market breaks out of its doldrums, worries over the economy's future begin to weigh on investors' psyches. After all, strong growth in payrolls has always been regarded as the final and most crucial element in a lasting recovery. But this is one of those times when good news on the economy is seen as bad news for the financial markets, since it means the Federal Reserve will begin lifting interest rates faster than the markets expected.

Of course, even the most somber of economic forecasts for 2004 had implied some pickup in job growth. What has been so surprising is how fast the job market is mending: 288,000 new positions in April, after 337,000 in March, bringing the total job gains since payrolls began to turn around last August to 1.1 million. In only eight months, that's 41% of the 2.7 million jobs lost during the previous 2 1/2 years.

Indeed, the Labor Dept.'s April employment report has sharply changed perceptions of the economy's health. The job numbers solidify the outlook for a strong second half because they lift prospects for consumer incomes and spending. Plus, improved employment bolsters the chances for a solid rebound in manufacturing, given that, for the first time in four years, factories felt the need to increase their payrolls for three months in a row.

But stronger-than-expected growth is not something investors should fear. The job data, combined with the first-quarter slowdown in productivity, imply that the gains in output growth are becoming better balanced between productivity increases and new jobs. That means more balance between profits and labor income, too. Although productivity is slowing, it remains strong enough to limit cost increases and support earnings.

JITTERY INVESTORS are focused squarely on the Fed. The financial markets are betting heavily on a quarter-point hike at the Fed's June 29-30 meeting. Some of the recent market churning is the result of players shifting away from investment positions that had been predicated on low short-term interest rates.

But more than that, the employment data suggest the economy may well be in a boom, growing much faster than the 4.1% pace of the past two quarters. If so, spare capacity is being used up a lot faster than expected, giving the Fed a bit more incentive to get its policy rate back up to a level that is more historically in line with a healthy economy. Moreover, strong job growth and the continued decline in the unemployment rate provide the Fed with the political cover to begin its tightening process, despite the looming Presidential election.

Hiring Is the Broadest in Four Years
This time, though, there may be less reason for investors to fear the Fed than in past tightening cycles. Policymakers will not be raising rates to cool off an overheated economy, as was the case in 1999-2000, when the jobless rate plunged to 3.8%. The economy still has room to expand rapidly before alarm bells go off, and inflation is lower than at the start of any other recent tightening cycle. As a result, the Fed has the freedom to act preemptively and at a "measured" pace, as the policymakers said after their May 4 meeting.

That freedom enhances the chance that the Fed can head off any serious price pressures before they develop, and thus engineer a soft landing, without higher rates sending the economy crashing into a recession. That feat would be similar to the outcome of the 1994 tightening, which helped to foster the era of prosperity in the 1990s.

THE MOST ENCOURAGING TREND in the latest job news is the depth and breadth of hiring. The gain of 625,000 jobs was the largest in a two-month period since 2000. Over the past three months, 64% of industries hired workers, also the best showing in four years (chart).

Even manufacturers are finally adding to payrolls, after job losses for 41 months in a row. The total of 37,000 new factory jobs since February is small, but it's a crucial piece of the recovery in manufacturing. The gains in jobs, as well as orders and output, reflect growing demand for U.S. goods both at home and abroad. In March, exports jumped 2.6% from February, although imports rose an even faster 4.6%, pushing the March trade deficit to a record $46 billion. For the quarter, real exports of goods were 8.9% above their previous-year level.

Private-service companies are also hiring at a stronger pace than they were in the last half of 2003. In April, service providers created 238,000 new slots, on top of 228,000 added in March. Temporary help agencies, health care, and hotels, restaurants, and bars led the hiring in April. But outsize gains were also posted in trucking, finance, professional services, building services, and membership associations.

THE RUSH TO HIRE is also generating some lift for wages. Hourly pay for production workers rose by a nickel, to $15.59, or by 2.2% from previous-year levels. This pay raise, when combined with the increase in jobs, will provide more money to support consumer spending.

Already, in the first quarter, the wages-and-salaries component of personal income was up 3.7% from the year before. That advance is far faster than the 1.6% gain in prices, as measured by the Fed's preferred inflation index, the personal consumption price deflator (chart). That means household buying power is expanding once again after it shrank for almost two years, through the first quarter of 2003. The renewed pay gains also signal that more of the income produced in 2004 will shift into consumers' pockets and away from profit ledgers.

But that doesn't mean profit growth will slow considerably this year. True, the year-over-year earnings comparisons won't look as robust as the recent surges of nearly 30% by some measures. But companies should still do well, in part because the latest job data show that productivity is only slowing from its recent breakneck pace. Given the imperative of global competition and the continued flow of efficiency gains from past investments in technology, the efficiency trend will not go into reverse.

A Healthy Rebound in Buying Power
In April, total hours worked in the nonfarm economy stood well above their first-quarter average. If payrolls continue to rise in May and June, hours worked in the second quarter will probably grow at an annual rate of 2% or more. Given that the economy is on track to expand at a pace of 5% or better, that means output per hour worked should rise by another 3% or so. That's after the first quarter's solid 3.5% advance.

While that pace is well below the 5.4% increase in productivity over the course of 2003, the rate is still healthy enough to keep unit labor costs from crimping margins. In fact, the growth in unit labor costs still trails the price markups companies are able to get for their products. In the first quarter, unit costs rose at a 0.5% annual rate, but prices rose by 1.9%.

The bottom line is that investors have little to fear from a strong economy or higher interest rates. Rates were unusually low because of worries over a weak economy. Now the Fed is set to move rates back to levels that are typical of those in a self-sustaining recovery. The latest job data are a reflection of the economy's new health.

By James C. Cooper & Kathleen Madigan

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