U.S.: The Double Whammy That Could Ignite Inflation
Stellar productivity growth in the U.S. has become such a common feature of the economic landscape, it's easy to take it for granted. That would be a mistake, especially now when efficiency gains are slowing down. This year smaller productivity increases will give businesses less of an offset to rising labor and other costs than in recent years. That will put pressure on companies to lift prices to keep profits from getting squeezed. At stake: the future path of inflation and interest rate decisions by the Federal Reserve.
Last year, productivity -- measured as output per hour worked at nonfarm businesses -- grew 2.9% from 2004, according to the Labor Dept.'s Mar. 7 report. That was a good showing, given that the pace was higher than the long-term trend, generally accepted to be about 21/4%. It was also impressive given the unusual weakness at yearend. Based on Labor's revised data, fourth-quarter productivity fell at a 0.5% annual rate from the third quarter, but that drop reflected the same temporary distortions from autos and weather that caused the sudden falloff in the economy's overall growth rate.
Looking through the quarterly ups and downs, productivity has slowed progressively for three consecutive years at a time when wages and benefits of workers have accelerated. Last year, compensation grew 5.5%, the fastest clip in five years. The likely continuation of these two trends in 2006 will become crucial for the inflation outlook, because it means unit labor costs will be speeding up.
Unit labor costs are compensation costs that are not offset by productivity gains, and they correlate tightly with inflation. Last year unit costs grew 2.6% from 2004, also the fastest pace in five years. Up to now, with productivity growing strongly, tight labor markets and upward pressure on wages have not presented much of a concern. But in the coming year, all that could change.
THIS YEAR, THE TRENDS in productivity and compensation will most likely continue to diverge. Productivity will follow its typical slowdown pattern as a business-cycle upturn gets older. Right after a recession, output per hour tends to surge as companies stretch their existing payrolls to meet demand. Later, as is happening now, those gains fade, as more workers are needed to boost production. At the same time, with job growth strong and labor markets already tightened to the point where wages are starting to grow faster, overall labor costs will continue to grow at an elevated pace.
The last time accelerating unit labor costs raised inflation alarms was in the late 1990s. Back then, the growth of unit costs surged from 0.7% in 1996 to 4.2% in 2000. However, that was when the world was awash in production capacity following the Asian crisis in 1997 and the financial turmoil after the Russian debt default in 1998. Growth outside the U.S. was generally soft, and the dollar had strengthened greatly. All this prevented U.S. companies from pushing through price increases to offset the additional cost of making one of their products. Instead, businesses suffered one of the sharpest contractions in profit margins on record.
Now, global conditions are much different -- and much more conducive to greater pricing power. Chinese demand is soaking up capacity throughout Asia, even as the Japanese economy emerges from its slump. Global labor markets are tighter as world growth continues to pick up. And the dollar is down sharply, to levels below those of the late 1990s.
As a result, it's not surprising that commodity prices are strong, and many companies have had more success in lifting product prices to cover their cost increases, especially energy costs. Nor should it be startling that companies are maintaining high levels of profit margins, despite the faster pace of unit labor costs.
THE DEGREE TO WHICH PRODUCTIVITY growth slows this year will depend a great deal on the number of new efficiencies that businesses can exploit from their existing technologies. To understand why that's true, consider that the technology boom since 1995 has driven productivity growth in two different ways.
From 1995 to 2000, the primary driver was massive business investment in new hardware and software that gave workers better technology to help them perform their jobs. During that time, price-adjusted business outlays for high-tech gear grew at about a 20% annual rate. But since the peak of the tech boom in 2000, productivity gains from new investment have eased, with tech outlays growing less than 5% per year. Only recently has the pace of tech investment re-accelerated, but growth still lags well behind that of the late 1990s.
However, during the past five years, a new productivity driver took over. Economists call it, in the simplest terms, technological progress. In not-so-simple terms, they call it multifactor productivity. It means that companies learned new ways to use their equipment more efficiently to reorganize and streamline their production and distribution processes. So despite the slowdown in the pace at which businesses were investing in new tech equipment, companies continued to make big gains in efficiency that helped to boost output and cut costs.
The good news is that the speedup in investment in information technology since 2004 is laying the groundwork for more gains in technological progress later in the decade. But in the next year or two, these types of productivity gains may well slow, especially since their contributions appear to have been far greater than their recent trend. Unfortunately, hard data on this productivity driver are lacking. The Labor Dept.'s official numbers run only through 2002, but that year's gain was more than twice the average in the previous 10 years.
THE PATTERN OF PROFITS and profit margins this year will say a lot about how businesses are coping with slower productivity and faster unit labor costs. In the second half of last year, unit costs grew a shade faster than originally estimated, mainly because the rise in wages and benefits turned out to be greater. Newly revised data show that wages and salaries in the third quarter grew at a 6.5% annual rate from the previous quarter, instead of 5%, and 4.7% in the fourth quarter, instead of 4.4%.
Even though productivity slowed last year, businesses more than covered the added compensation costs with higher prices. On average, the labor cost of making a given item sped up to 2.6% last year, but the price of that item increased slightly faster, at 2.8%, up from 2.1% in 2004. That means profit margins held up well last year.
This year, businesses will continue to test the markets to see how much additional pricing power they can muster. Given the combination of strong demand and rising utilization rates, both in the U.S. and overseas, it is likely that companies will find more pricing leverage. If so, that could be a mixed blessing for investors. Profits would continue to grow at a healthy pace, but interest rates would be sure to climb further as the Fed becomes increasingly concerned about prospects for inflation.
By James C. Cooper