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U.S.: What Could Spoil The Fed's Slowdown Scenario


Investors are betting heavily on the Federal Reserve's forecast of slower growth, tame inflation, and less pressure on the labor markets and production capacity. But the real question investors should be asking is: How much faith does the Fed put in its own projections? Back in February, the Fed expected the economy to grow about 3.5% this year, with core inflation holding at 2% and the unemployment rate ending the year between 4.75% and 5%. If the Fed believes those numbers, then the quarter-point hike in its target rate, to 5%, on May 10 might be the last for a while.

The trouble is, there's not much evidence that the Fed's forecast is playing out the way policymakers would like. The latest reports from the labor markets show why. Payroll gains in April did seem to cool, but jobs are still growing fast enough to push the unemployment rate lower and keep upward pressure on wage growth.

Plus, the recent trend in productivity growth has slowed, meaning that more rapid wage growth is pushing up unit labor costs. Faster unit costs, along with higher charges for energy and materials, are giving companies a reason to raise prices, and they appear to be having some success. Despite increased costs, first-quarter profits, even outside the energy sector, look very healthy.

Second-quarter economic growth will not keep up with the first quarter's rapid clip of nearly 5%, but the March and April data show plenty of momentum. Outside of payrolls, all the other April labor market indicators look pretty warm, including wage growth, which was red-hot. The job numbers also imply that industrial output continues to accelerate, far outstripping the growth in production capacity. All in all, it's a pattern that does not instill much confidence that inflation will stay benign and that the Fed will be able to pause in June.

After its May 10 hike, the Fed's post-meeting statement appeared to be crafted in a way to give policymakers maximum flexibility. The Fed put the possibility of a pause on the table, while saying subsequent policy decisions would depend on how the data behave. But the numbers so far, especially those from the labor markets, make it hard to rule out a June hike.

START WITH THE APRIL employment report. On the surface, it offered conflicting signals. The 138,000 gain in payrolls was weaker than expected, suggesting the slower growth scenario. But other key readings from the report look strong, including big gains in overall hours worked and average hourly pay.

The small payroll gain appears to be the anomaly. The softness was concentrated in the service-producing sector, including an unusually large 36,000 drop among retail businesses. That decline followed a singularly large advance in March, and it doesn't square with widespread reports of strong April retail sales. The drop might be related to the timing of Easter and its effect on the way the government adjusts its raw data for seasonal employment variations.

More important, the April increase in private service sector jobs of only 94,000, vs. a much stronger average monthly gain of nearly 150,000 in the previous six months, is at odds with other positive April readings from the service sector. Notably, the Institute for Supply Management's index of business activity among nonmanufacturers, mostly service producers, rose strongly last month, far exceeding its first-quarter average. Also, the ISM's index for service sector employment rose to a level consistent with solid job growth. Consequently, the tepid April rise in service payrolls does not seem to be the start of a slowing trend.

THE REST OF THE JOB REPORT showed plenty of strength. The April unemployment rate remained at a low 4.7%, and overall hours worked, comprising both employment and the workweek, rose 0.5% from March, the largest increase since last summer. So far this year, total work time is climbing at a 3.5% annual rate, the fastest four-month growth in two years. The big advance in April puts hours worked in the second quarter on a pace to exceed the 3% rise in the first quarter. That's a strong sign that the economy is retaining some of its first-quarter pizzazz.

The forward thrust in manufacturing is especially clear. Factories added 19,000 workers to their payrolls in April, the largest monthly gain in two years. That means second-quarter factory output shows little sign of slowing from its 5.8% growth rate in the first quarter. Strong factory output is placing increasing demands on production capacity. Over the past year, manufacturing output has grown at twice the rate that new production capacity is being put in place. The utilization rate is already above its long-run average, a level that can often create tight market conditions and higher prices.

SO FAR, THE POTENTIAL inflation pressures from tight labor markets have not been worrisome. But that may be changing. April hourly earnings of production and nonsupervisory workers, which make up about 80% of private-sector payrolls, jumped a sharp 0.5% from March, and over the past year pay has grown 3.8%, the fastest yearly advance in five years. The pace is accelerating. So far this year the annual growth rate of hourly pay has clocked in at 4.8%, the most rapid four-month clip since 1997, led by strong growth in service sector pay.

The pickup in pay is a key reason why households continue to spend, despite the runup in gasoline prices. The underlying momentum of income growth is evident in a gauge based on the product of overall hours worked and hourly pay. This proxy for wage and salary income in April, to be reported later this month, rose a steep 1% from March, and the yearly growth rate, at 6.3% last month, continues to speed up. Consumer spending this quarter is sure to ease from its robust 5.5% annual rate in the first quarter, but labor markets continue to provide ample support to basic household income.

Of course, pay gains are not inflationary as long as productivity is growing fast enough to offset upward pressure on unit labor costs. But that's the crucial question. Productivity growth in the first quarter, measured as output per hour worked, rebounded to a 3.2% annual rate after declining 0.3% in the fourth quarter. But over the past two quarters, the wages, salaries, and benefits paid to workers have increased well faster than productivity. First-quarter compensation grew at a 5.7% annual rate.

Even if the Fed's forecast of 3.5% economic growth is on target, pressure on wages isn't guaranteed to ease. Last year the economy expanded 3.2%, and the unemployment rate fell by half a percentage point. If that pattern holds, the jobless rate could decline to 4.4% by the end of 2006, well below the 4.75% low end of the Fed's expectation. Moreover, core inflation so far this year is running at a 2.5% annual rate, a half-point above the Fed's projection.

For now, investors would be wise to assume that the Fed's forecast is wrong until proven right. If the Fed has the same view, then a June rate increase may not be out of the question.

By James C. Cooper


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