U.S.: Strong Labor Markets Put The Fed On The Spot

Productivity growth was Alan Greenspan's best friend, but it might be turning into Ben Bernanke's worst enemy. In the late 1990s big gains in corporate efficiency--compelled by global competition and enabled by new technologies--were the key factor that held down inflation. The three years ending in 1999 saw productivity gains accelerate, on average, at a pace of 2.8% annually, up from a rate of 1.4% the previous three years. That speedup allowed the economy to grow strongly and at unusually low rates of unemployment, without causing the kind of price pressures the Greenspan Federal Reserve would have had to beat down by jacking up interest rates.

What a reversal. As of the third quarter, the three-year growth rate of productivity has slackened dramatically, from a peak rate of 4% per year in 2003 to only 1.9%, the slowest in nine years. The Labor Dept.'s latest report shows that third-quarter productivity, measured as output per hour worked, posted no gain from the second quarter, and was up a meager 1.3% from the previous year. Even that pace is set to be revised downward early next year, when Labor incorporates a recent data revision showing Americans worked more hours at more jobs from March, 2005, to March, 2006.

THIS TURNABOUT THREATENS to create a thorny problem for the Bernanke Fed. The productivity slowdown means the economy has less room to grow without generating inflation than it did in the late '90s and early this decade. That is becoming especially clear in the labor markets, which continued to tighten in October even as economic growth slowed. The result: All major gauges show labor costs picking up at a time when most companies' productivity gains are too weak to offset them. Historically, such cost pressures have found their way into higher prices.

Those pressures come from unit labor costs, or pay adjusted for gains in productivity. If a company can offset a pay raise with an equal increase in productivity, the cost of making each product, or unit, doesn't change. But if the unit cost rises, then its price must increase, or profits get squeezed.

The Fed's predicament: If economic growth picks up after its midyear slowdown, which looks likely, the labor markets will tighten further and inflationary pressures will keep building. The Fed's benchmark price index (which gauges increases from a year ago) is already running above the policymakers' favored 2% limit. In such a situation, the Fed's hopes for slower growth that would combat inflation would fade. Policymakers would be left with little recourse but to resume hiking rates, and that could put the financial markets, housing, and the economy at risk later in 2007.

FOR NOW, WALL STREET and many economists are convinced that Fed policy will remain on hold for a long time. But the job markets' surprising strength in recent months casts doubt on that outlook. While economic growth slowed to an average annual pace of only 2.1% in the middle two quarters, unemployment still fell from 4.7% in March to 4.4% in October, a 5 1/2 -year low. The job data indicate that, without an extended period of sluggish growth, potential inflation pressures from the labor markets will continue to build.

By any measure, the growth in unit labor costs is speeding up. The question is, how fast? Several Fed officials have downplayed the cost data in the Labor Dept.'s third-quarter productivity report, because its measurement of labor compensation appears to have been exaggerated earlier this year by one-time bonus payments and exercised stock options. This measure shows unit labor costs last quarter grew 5.3% from the previous year, the fastest pace since 1990 and twice as fast as a comparable measure of prices. But if that were true, corporate profits would be getting shellacked right now, and that's not happening.

In fact, according to Thomson Financial (TOC), with 407 of the Standard & Poor's 500-stock index companies having reported, third-quarter earnings are heading toward an average increase of more than 18% from the previous year. Of the reporting companies, some 73% have announced higher-than-expected earnings, far above the 60% average since 1994.

Still, other measures of workers' pay are also growing faster. Average hourly earnings of production workers rose strongly last month, and for the three months ended in October, hourly pay is up 4% from the year before. This time last year, the annual pace was 2.8%.

Even the quarterly employment cost index (ECI), which includes wages and benefits, is beginning to pick up. Many economists and Fed officials follow the ECI, saying it is more stable and adjusts for the changing mix of high- and low-paying jobs. Yearly growth in the ECI slowed from early 2004 to early 2006, from 3.8% to 2.8%. But in the last two quarters its growth quickened, to 3.3% in the third quarter, the fastest in a year and a half. So even by this measure, with lower productivity, unit labor costs are rising faster than before.

FED POLICYMAKERS COULD rest easy if only there was sufficient evidence that the economy would, for some time, remain as meek as it was in third quarter, when it grew at an annual rate of only 1.6%. That would justify hopes that the labor market's tightness would ease, at least enough to alleviate inflation concerns. It just doesn't seem to be happening. Businesses are still expanding to meet growing demand, and their new hires are earning plenty of income to spend. Both businesses' capital spending and consumers' purchases show every sign of growing faster this quarter than they did in the third.

Job growth since March, which covers the slowdown period, has averaged 134,000 new slots per month, thanks partly to large upward revisions to the data on job growth for August and September. That pace, if sustained, is brisk enough keep downward pressure on the unemployment rate, preventing any easing in labor-market conditions.

Moreover, the job data show that the midyear slowdown was confined to construction and manufacturing. Gains in service-sector payrolls--more than four-fifths of all jobs--sped up in recent months. Clearly, there is more weakness to come in housing and factories, as both sectors work through bloated inventories, especially the auto industry. That all will require further production cutbacks in the coming months. But signs still point to continued strength elsewhere more than offsetting those soft spots.

The key question Fed officials must grapple with is this: Is the unemployment rate already low enough to create ever-rising pressure on wages and prices? Right now, the Fed expects an economic slowdown sufficient to generate enough slack in the labor market to allow price pressures to ease. But with productivity growth fading and the jobless rate still falling, policymakers are bound to get increasingly uncomfortable with the way the inflation outlook is shaping up.

By James C. Cooper

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