How much more productivity can American businesses squeeze from their operations? Based on the June report from the labor markets, the best efficiency gains for this business cycle may be history. If that's true, you can bet that the profits boom of recent years will be winding down sharply in the coming year. But at the same time, consumers might actually benefit. It's all the result of tight labor markets, which could be even tauter than implied by the tepid gains in payroll jobs over the past three months.
Companies have been ultraconservative in their hiring as compared to past business cycles. The recovery of job growth to its pre-recession peak took much longer than in the jobless recovery after the 1990-91 recession. A combination of new technologies, competition, and streamlined management practices reduced the need for costly new hires and helped to boost productivity growth well beyond its long-term trend, and profits have soared to a record share of national income. But that was when labor markets were looser, and businesses could easily find all the labor they needed.
Now the table is starting to turn. Businesses need more workers to meet demand, and they are paying more to attract them. The most efficient workers already have jobs, and less-efficient first-time entrants into the labor force, especially younger workers, are looking for jobs in larger numbers. Reports of labor shortages at certain skilled positions are common. The unemployment rate, 4.6% in June, is the lowest in five years, and despite the recent slowdown in payroll growth, it will most likely drift lower in the second half of the year.
As a result, productivity is slowing and labor costs are picking up, on top of the surge in energy costs. Hourly earnings of production workers are growing at an ever-faster rate. In June they were up 3.9% over the past year, also a five-year high. Profit margins seem likely to shrink, which will slow overall earnings growth. But meanwhile, households are enjoying more income from their labors. And that's a key reason why consumer spending, while slower last quarter, is not about to collapse.
THIS IS NOT THE SAME labor market as a decade ago, when the jobless rate was this low. Globalization and outsourcing remain a fact of life, but world markets are much tighter now than in the late 1990s after the Asian currency implosion, and Japan and Europe are stronger, too. Global markets offer less of a safety valve for the growing pressures on the U.S.
Most of the attention on the June employment report was directed at the smaller-than-expected rise in payrolls, which increased by 121,000, after disappointing gains in both April and May. But the more interesting number was the 0.4% monthly rise in overall hours worked. For the quarter, hours increased at a sturdy 2.3% annual rate from the first quarter.
Given that productivity is defined as output per hour worked, the hours increase leaves little room for any significant growth in productivity. Even if gross domestic product last quarter grew in the neighborhood of 3%, which is close to the current expectation, productivity would struggle to rise 1%.
Coming at a time when labor compensation is picking up, that slim gain means businesses either have to absorb the higher costs in their profit margins or try to lift prices to make up the difference. Up to now, efficiency gains have been large enough to offset rising pay, but that will be more difficult to do in the coming year, as labor markets tighten further.
JOB MARKETS ALSO HAVE CHANGED in that it appears to take even less employment growth now to reduce the jobless rate. As a result, the recent slowing in payroll gains may not necessarily mean either looser job markets or weak consumer spending.
For example, until the past few years, analysis shows that job gains averaging about 150,000 per month were sufficient to absorb new job seekers and hold the unemployment rate steady. However, during the past year, payroll increases have averaged 155,000 per month, and the jobless rate has fallen 0.4 percentage points. In the first half of 2006, growth has slowed to 142,000 per month, and the unemployment rate has continued to drift down, from 4.9% at the end of last year to 4.6% in June.
Despite the payroll slowdown, job openings remain at a high level. Indeed, the Labor Dept.'s Job Openings & Labor Turnover Survey for May shows that the rate of job openings -- calculated as the amount of unfilled jobs relative to overall employment -- held at 2.9%, which is the high for the current economic expansion. The rate has been steady at that level all this year. Labor said the industries with the highest job opening rates in May were professional and business services, the leisure and hospitality sector, and education and health services.
ALTHOUGH PAYROLL GAINS eased in recent months, the combination of more work hours and faster growth in hourly pay is translating into solid income growth for households. Multiplying hours times pay, which gives an approximation of household income from wages, shows that second-quarter income rose at a 7% annual rate from the first quarter, following a similar advance in the first quarter from the fourth. This income gauge has not shown back-to-back quarterly gains of that size since the late 1990s, the last time labor markets were this tight.
Part of the smaller payroll gains in recent months might well reflect some temporary uncertainty among companies over how higher interest rates and the spring surge in oil and gasoline prices would affect demand. The fact that businesses still boosted the hours worked by their employees suggests that demand, while constrained, was not severely or permanently damaged.
Clearly, both consumer spending and housing took a hit last quarter, and the softer tone of those two sectors shows up disproportionately in the job data. Overall job growth averaged 108,000 per month last quarter, down from 176,000 in the first quarter. However, jobs in retail trade and residential construction, which are only 14% of total payrolls, accounted for 57% of that slowdown.
Elsewhere, job growth and economic activity are holding up well, especially in manufacturing. Factories added 15,000 jobs in June, and they boosted their workweek by 6 minutes, to 41.3 hours. That implies another solid rise in June industrial production. Businesses both at home and abroad are expanding their operations and their capital spending. Factories are especially benefiting from surging exports, which posted another strong increase in May, helping the non-oil trade deficit to narrow significantly in recent months.
For now, businesses still have abundant profits and a backlog of past efficiencies to use for growing their operations. But every business cycle eventually reaches a point where productivity and profits begin to slow and households begin to grab a bigger slice of national income. That moment is getting ever closer now, as labor markets continue to tighten.
By James C. Cooper