U.S.: Low Unemployment Raises An Old Inflation Debate

Should the Fed keep hiking rates in the face of a tighter labor market?

Remember NAIRU? Sounds just like "Nehru," but it's not one of those collarless jackets popular in the 1960s. NAIRU is the acronym for Non-Accelerating Inflation Rate of Unemployment, the clunkiest phrase economists ever devised. It was last heard amid the inflation debate in the late '90s. In plain English, NAIRU is the lowest the unemployment rate can go without generating a sustained pickup in inflation. On the heels of the strong January employment data, the debate now begins anew: When should policymakers and investors start to worry about the inflation implications of tight labor markets?

Vigorous job growth, including 687,000 new payroll slots in just the past three months, pushed the jobless rate down to a 4 1/2-year low of 4.7% last month. Hourly pay of production workers, up 3.3% from a year ago, is rising at the fastest pace in nearly three years. And job growth is generating plenty of income to support consumer spending, which is a key reason for the economy's forward thrust in early 2006. That momentum will only tighten the labor markets further.

At the end of last year, the Federal Reserve first voiced its concern that "possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures." That's Fedspeak for "if the labor markets get too tight, we might have to take policy past the neutral zone into an area that actually restricts economic activity." Back then, the unemployment rate was 5%, job growth was hobbled by the hurricanes, and the economy appeared to be slowing down. Now the landscape is starting to look less inflation-friendly.

AS WAS CLEAR IN THE LATE '90s, the importance of NAIRU is more theoretical than practical, because the rate is a moving target, shifting from business cycle to business cycle with the changing structure of the economy. Recall that, by 2000, the jobless rate had dipped a tick below 4% with little evidence that inflation pressures were building in any big way.

However, 2006 may well be different from the late 1990s, because the unemployment rate may not have as much room to fall as it did back then. Inflation in the late '90s was restrained by several forces. Fed policy was already in the restrictive zone, based on the Fed's inflation-adjusted policy rate, even before the Fed began to tighten in 1999. A global production capacity glut following the Asian crisis in 1997 sent deflationary waves rippling through the world economy. The dollar was soaring, holding down import prices. And productivity growth was accelerating as new technology blossomed.

Productivitiy Growth Is Tapering Off
In 2006, Fed policy is only neutral, and it has been exceptionally loose for four years. Global competition still is clearly anti-inflationary, but domestic demand in global economies is either strong, as in China and the rest of Asia, or improving, as in Japan and the euro zone. The broad trade-weighted dollar has fallen 15% from its peak in early 2002, with further declines likely this year. And importantly, productivity growth in now slowing.

Productivity of nonfarm businesses in the fourth quarter fell at a 0.6% annual rate from its third-quarter level. That drop was worsened by the weak fourth-quarter gross domestic product, which was distorted by several temporary factors. Both GDP and productivity will look stronger this quarter, but the slowing trend in productivity will remain in place at a time when labor markets are tightening and wages are starting to grow faster. Slower productivity growth reduces the ability of businesses to offset higher labor and other costs, increasing the pressure to lift prices.

PRODUCTIVITY OVER THE PAST TWO YEARS has grown at a 2.4% annual rate. That's not bad in a historical sense, but it's the slowest two-year pace in almost five years. The pace will most likely cool off further in 2006. In recent years companies have been exceptionally hesitant to invest and hire amid the uncertainties of corporate scandals, war, and energy shock. Businesses have satisfied demand with their existing facilities and payrolls. That reluctance temporarily boosted productivity.

But corporations have taken their short-term efficiency gains about as far as they can. With demand still strong, the recent robust job gains suggest that companies are ready to rely more on additional workers and less on greater productivity to meet their growth in production. That pattern doesn't rebut the improved long-term outlook for productivity growth, but in the short term, it is a typical trend as an economic expansion matures. It just took a little longer for it to show up this time.

The inflation concern is that productivity is slowing at a time when wage growth is picking up. That's a recipe for faster increases in unit labor costs, which correlate with inflation outside of energy and food. Over the past two years, the yearly growth of hourly pay of production workers has accelerated from 1.6% to 3.3% in January. In the fourth quarter, a broader measure of hourly pay, the Labor Dept.'s employment cost index, showed the first rise in yearly wage growth in two years. Amid resilient demand, businesses have a little more pricing power and thus greater ability to cover their higher costs.

It's also interesting to note that the employment cost index for benefits has slowed sharply during the past year, from a 7.1% yearly pace to only 4.1% last quarter, reflecting mainly a tight reining-in of health-care costs. Greater control over benefits will give companies more leeway to grant hikes in regular pay in order to attract workers with the particular skills companies need.

THE OTHER SIDE OF STRONGER JOB MARKETS is the support they are providing consumer confidence and spending. That will be important in the coming months, as housing and home values cool off, and as households stop using their homes as ATMs.

Household Income's Firm Underpinnings
The underlying momentum of income growth shows up in a calculation based on recent labor market data on jobs, the workweek, and hourly pay. This gauge tracks the trend in overall wages and salaries, although it includes only production workers and excludes bonuses and other forms of pay such as stock options. In January it was up 6% from a year ago, the strongest yearly pace since before the recession began in early 2000. Little wonder why January consumer confidence hit a 3 1/2- year high.

To some extent, recent job gains reflect a bounce back from the hurricanes and unusually mild January weather. However, over the past year, monthly job growth has averaged about 175,000 slots per month. As a result, the unemployment rate has declined by half a percentage point. If job growth continues at that rate, and the extremely low level of new unemployment claims heading into February suggests that it will, then the jobless rate could be below 4.5% by summer.

So, while the key NAIRU level remains fuzzy, what's clear is that the economy moved a lot nearer to it in January than anyone expected it to only a few months ago, and that marker will get even closer in the coming months.

By James C. Cooper

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