U.S.: Investors May Be Celebrating Too Soon

Revised numbers show labor costs could keep the heat on inflation

When Washington reported that the economy's growth rate slowed to 2.5% in the second quarter, both stock and bond investors whooped and hollered. Their buying spurred rallies reflecting the belief that the economy is slowing enough to ease inflation pressures and forestall the need for more interest rate hikes by the Federal Reserve. Maybe they should look a little deeper into the report, especially at the implications of the government's revisions covering all the data in the national accounts over the past three years.

The picture that emerges is not as comforting as the one investors thought they were looking at, especially with regard to the inflation outlook. For the coming year, the new data suggest the Fed's task of keeping prices subdued will be more difficult than the earlier numbers had implied.

It's not just that the trend in inflation outside of energy and food is now slightly higher than earlier data had shown. The revisions also indicate the economy might be more inflation-prone now than it was in the late 1990s. In particular, the new numbers imply that pressure on labor costs from tight job markets are ready to play a more active role in pushing up inflation.

The Bureau of Economic Analysis (BEA) reported that economic growth during 2003 through 2005 is 0.3 percentage points per year slower than first estimated, pulled lower in large part by a big downward refiguring of business investment, which means productivity growth is also slower. More striking, revised data show an accelerating growth trend in labor compensation, including both wages and benefits, not a slowdown as seen in the previous data.

For the Fed, these are unwelcome patterns. Until now, the numbers demonstrated that strong productivity gains were almost wholly offsetting subdued growth in compensation, a mix good for keeping the wage/price spiral from cycling upward. The new data suggest preventing such a spiral will be a much tougher task now. All in all, these trends mean that even if the Fed chooses to take a break from rate hiking at its August and September meetings, its work is not necessarily finished.

THE BEA'S REVISIONS place special attention on the Bureau of Labor Statistics' (BLS) upcoming report on productivity and costs, due on Aug. 8. The report will include the BEA's updated numbers on overall output and labor compensation and will give a more accurate picture of just how much productivity has slowed. More important, it will show how much pressure is building on unit labor costs, or compensation costs not offset by productivity gains. Unit labor costs tend to be tightly correlated with inflation trends.

A Radically Different View Of Pay Growth
The cost pressure could turn out to be substantial. We now know that, through the first quarter, labor income from wages and benefits grew 6.2% from a year ago, up from a yearly growth rate of 5.6% in the first quarter of 2005. That's a sharp reversal from the old data, which had shown a slowdown from 7.3% to 4.6%. Moreover, in the second quarter, over-the-year growth accelerated even more, to 6.8%, the fastest such clip in 5 1/2 years.

Through the first quarter, current BLS data show unit labor costs up a mere 0.3% from a year ago. However, back-of-the-envelope estimates by several economists, taking into account the expected slowdown in productivity, suggest that, through the second quarter, the BLS's new data will show unit labor costs rising about 2.5% to 3% over the past year. Depending on the mix of revisions, that could be the fastest pace in five years. Certainly the new trend will present a radically different picture than before, suggesting more intense pressure on companies either to lift prices to cover the added cost or to thin their profit margins.

INDEED, THE NEW DATA imply higher costs have resulted in faster inflation and lower profits than originally thought. Based on the government's economywide profits tally through the first quarter, the revised numbers show that earnings growth remained strong but not as robust as portrayed by the earlier data. Profits rose 18.9% from a year ago, instead of 28.5%, and margins, while still high, were lower than first measured.

Meanwhile, outside of energy and food, the price index for personal consumption expenditures -- the Fed's principal inflation gauge -- rose at an annual rate of 2.9% from the first quarter, the largest quarterly pickup in 12 years. Measured from a year ago, the pace of core inflation through June stood at 2.4%, already close to the 2.5% top end of the Fed's forecast range for all of 2006.

Additional pricing power might well be one of the reasons why profit growth continued to beat expectations in the second quarter. Through July 28, Thomson Financial (TOC ) says that, with 322 of the Standard & Poor's (MHP ) 500 companies having reported earnings, 69% have beat analysts' expectations, well above the typical 60% for a given quarter. If current expectations for the remaining 178 companies are met, Thomson says S&P 500 earnings would be up 14.8% from a year ago, far above the 10.9% gain expected at the start of the quarter. Even without the energy sector, profits would be up 11.4%.

THE POTENTIALLY DISTURBING question, especially for policymakers at the Fed, is this: Has a lack of business investment in recent years, along with a new lower trend in labor force participation, reduced the economy's noninflationary speed limit? That is, does the economy still have the same freedom to grow as rapidly as it has grown since the late 1990s without sparking inflation?

It was business investment, particularly in tech equipment, that helped to expand the economy's underlying growth rate of productivity, and thus to grow faster than it did in the 1980s without generating inflation. However, the revisions to economic growth show a much lower trajectory for investment in business equipment. In the three years from 2003 to 2005, equipment spending grew 7.3% per year, not 9.8%, as earlier data showed, and outlays for information processing gear rose 9.4% per year, not 12.2%.

Business Investment: Less Than You Thought
Equipment outlays for the second quarter alone, although coming as they did on the heels of a strong first-quarter gain, were surprisingly weak. Spending fell from the previous quarter for the first time in more than three years, as did high-tech investment.

A rising amount and quality of equipment available to workers is a key component of productivity growth. However, even before the revisions, the dollar value of business investment as a share of gross domestic product was still well below the 12.6% peak reached in the late 1990s. Now, at 10.4%, the share is even lower than before. Even after 4 1/2 years of economic recovery, the share remains below the 10.9% average since 1960.

On balance, the BEA's revisions tell a consistent story of less investment, less productivity, fewer profits, more labor income, and higher inflation. That's not a combination that should bring comfort either to the Fed or to investors.

By James C. Cooper

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