BUSINESSWEEK ONLINE : NOVEMBER 13, 2000 ISSUE
BUSINESS OUTLOOK U.S.: Taking the Pulse of the Slowdown Is it enough to keep rising labor costs from posing an inflation threat? Policymakers at the Federal Reserve got an early holiday gift on Oct. 27 when the Commerce Dept. released the third-quarter gross domestic product report. The data indicate that the economy is heading toward the Fed's desired soft landing--that is, a period of growth slow enough to assure that inflation remains contained. Last quarter's slowdown was impressive. Real GDP grew at an annual rate of 2.7%, less than half of its 5.6% pace in the second quarter. Domestic demand rose 2.7%, the slowest pace in three years (chart). What's behind the slowing? Two crucial supports have held up domestic demand over the last few years: strong labor markets and accommodative financial conditions. Job markets still appear tight. But thanks to past Fed tightening, money is not flowing as easily to households and businesses as it once did. That's the new factor in the outlook, but the extent of its drag on growth remains to be seen. Bear in mind a one-quarter respite isn't long enough to address the Fed's chief concern that domestic demand is growing far faster than supply. That's especially true given that tight job markets are pushing up labor costs. Compensation in the third quarter, measured by the employment cost index, rose at its fastest four-quarter pace in 10 years. One potential problem for the Fed next year could be that slower economic growth will also cool off productivity growth, even as labor costs continue to rise (page 54). In addition, the GDP mix suggests that the slowdown to a sub-3% growth rate is exaggerated. The government and housing sectors subtracted a full percentage point from third-quarter GDP growth. Those drags won't be repeated this quarter, given the sizable amount of election-year pork making its way through Congress and the sharp rebound in housing demand in September. Unless the Fed believes the economy has cooled off for the long haul, policymakers will not remove the threat of higher interest rates. THE FED CAN TAKE HEART that tighter financial conditions are starting to slow the two main components of domestic demand: consumer spending and business investment. Given the flattening out of stock prices this year, the wealth effect for consumers is diminishing. Similarly, capital spending is feeling the squeeze from costlier equity financing, tighter credit-market conditions, and pickier banks. Consumers will be the key to the soft landing, and signs are evident that households are not spending as rapidly as they had been. Real consumer spending rose 4.5% last quarter, a bounceback from the 3.1% pace of the second quarter. But taking both quarters together, outlays have grown at a 3.8% annual rate, far less than the 6.8% gallop of the previous two quarters. Looking ahead, spending gains are sure to slow more in line with the increase in household incomes. In the past year, outlays have grown 5.3%, some two percentage points faster than the 3.2% pace of income, reflecting the added spending power of the wealth effect. Now that stock prices have stopped rising at double-digit rates, that gap will narrow. Also, consumers were less optimistic about their economic prospects in October. The Conference Board's index of consumer confidence plunged from 142.5 in September to 135.2, the lowest reading in a year (chart). The Board said that a cooling economy ''and apprehension regarding soaring oil prices and volatility in the financial markets'' triggered the decline. Those factors have not gone away, but with the price of oil below its October peak and with stock prices firming, they are less worrisome now. Consumers are still confident enough to keep buying homes. Sales of new single-family homes jumped 9.2% in September, to an annual rate of 946,000. That cleared out some of the inventory of unsold homes and suggests that residential construction will probably rise this quarter after falling at a 9% pace in the third quarter. But with the wealth effect dissipating, the rebound is unlikely to be as strong as past increases. AT THE SAME TIME, businesses are expected to become more selective about what they spend their money on, now that financing is more expensive. Real investment in business equipment grew at an annual rate of 8.5% in the third quarter, about half of the 17.9% gain in the previous quarter. But a 10% contraction in outlays for transportation equipment accounted for much of that slowdown. Outlays for information-processing gear climbed 19.6%, not much of a slowdown from the 27.7% rise in the second quarter. Businesses are not going to take an ax to their capital budgets. They must continue to lift productivity in order to stay competitive. But investment will slow over the next year because of tighter financial conditions, including access to equity capital, bond-market credit, and bank financing. Plus, businesses will be less able to tap into internally generated funds because profits will continue to be under pressure from slowing revenues and rising labor costs. One area of business spending that is almost certain to be a drag on future growth is inventory accumulation. Stockpiles grew at a faster clip in the third quarter than their already quick pace of the second. With demand cooling, businesses in the future won't need to lay in so much merchandise or supplies. That's one reason the purchasing managers' index of industrial activity declined to 48.3% in October, from 49.9% in September. THE KEY QUESTION about the slowdown and Fed policy is this: Is growth slowing enough to assure that rising labor costs do not present an inflation threat next year? On that one, the jury is still out. Through the third quarter, the growth rate of worker compensation continued to head upward. In the third quarter, the employment cost index for private-sector employees--a measure of what companies shell out for wages, salaries, and benefits--rose 4.6% from the year before. That's the fastest four-quarter clip since 1990. Unless the economy slows enough to loosen up the labor markets, then workers' pay and benefits are very likely to grow even faster in 2001. Although yearly wage growth is up about a percentage point from this time last year, to 4.1%, the culprit in the overall acceleration is benefits, some 27% of compensation (chart). The cost of bennies, ranging from health care to paid leave and retirement plans, rose 6% during the past year. That pace is more than double the 2.8% pace posted this time last year. Higher health-insurance premiums have been a big contributor to the speedup. Given the trend in labor costs, any slowdown in productivity will be sure to raise unit labor costs next year. At that point, the economy--and the Fed--would face a double whammy: upward pressure on inflation and downward pressure on profits. By JAMES C. COOPER & KATHLEEN MADIGAN _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP					RELATED ITEMS U.S.: Taking the Pulse of the Slowdown CHART: Demand Is Cooling Off from Its Red-Hot Pace CHART: Oil and Stock Prices Roil Households CHART: Benefits Continue to Push Up Labor Costs INTERACT E-Mail to Business Week Online

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