The Federal Reserve always seems to be on the horns of one dilemma or another. It's the nature of the job: Controlling inflation quite often has negative implications for economic growth and unemployment. For now, the Fed's decision to hold its target interest rate steady at 5.25% on Mar. 21 looked easy enough. The economy has slowed materially, and the policymakers believe that slowdown will allow inflation to ease. However, a growing number of economists believe, despite the cooler pace of growth, bringing inflation down to where the Fed wants it won't be so easy.
What seems to be happening is a gradual undoing of the high-growth/low-inflation Eden of the late 1990s and early 2000s. Back then, technological innovation fueled a speedup in productivity growth that helped the economy grow faster, create more jobs, and generate faster pay growth—all without boosting inflation. Meanwhile, the dollar was soaring, global growth outside the supercharged U.S. was sluggish, and there was a glut of production capacity. That meant falling prices of U.S. imports and plenty of foreign competition to help restrain prices of U.S.-made goods.
Times have changed—both at home and abroad—and in ways that will make the Fed's job of controlling inflation more difficult than before. Even though the economy has slowed substantially over the past year, inflation is still higher than the Fed would like. Also, labor cost pressures continue to grow, as job markets tighten further and the unemployment rate keeps falling.
In spite of new uncertainty stemming from the subprime mortgage mess, the Fed must maintain a tough stance against inflation, even if that policy risks magnifying the problems in housing and the economy. As the policymakers' Mar. 21 meeting statement showed, the Fed is still more concerned about rising inflation than it is about a weaker economy. Investors currently expect the Fed to cut rates later this year, but new forces at work in the economy will most likely rule that out.
GLOBAL CONDITIONS are now far less conducive to keeping inflation down. Growth is strong around the world, with little slack in production capacity. That's why central banks from Europe to Asia are lifting interest rates in an effort to preempt inflation. Even Japan is on a path to higher rates after years of deflation. And given the dollar's decline since early 2002, prices of imported goods other than fuels are up 2.5% over the past year, in contrast to the late 1990s, when they were falling.
The most important forces working against the Fed are homegrown, most notably the recent slowdown in U.S. productivity growth. Up to now, strong productivity gains have given the economy more room to grow without pushing up inflation. The drop-off appears to be more than just a short-term blip caused by the ebb and flow of the business cycle. For the first time in a decade, the five-year growth rate of productivity is headed sharply in the wrong direction. It's down to 2.6% per year at the end of 2006 from a peak of 3.4% in 2004, and the slowdown is picking up speed. The three-year pace has dropped to only 1.8% annually, close to a 10-year low.
WHY THE SLOWDOWN? For one reason, businesses are investing far fewer dollars in new equipment and software as a share of overall gross domestic product. Even though companies are sitting on a ton of cash, while enjoying relatively easy financial conditions and pristine balance sheets, yearly growth in outlays for equipment, adjusted for prices, slowed to only 4.4% last year, the weakest pace in more than three years. Workers are clearly more productive than they were a decade ago, but the gains in their efficiency appear to be tailing off.
Also, much of current corporate outlays are for replacement of worn-out computers and other short-lived tech equipment. New computers are faster than older ones, but fewer innovative ways to use them may be another reason for smaller gains in corporate efficiency. Economists at JPMorgan (JPM) note that the pace of technological innovation appears to be slowing down, citing a reversal in the pattern of prices of high-tech equipment and software. Rapid innovation in the late 1990s showed up in sharply falling tech prices, but the trend now is a progressively slower rate of decline.
Researchers at Morgan are not alone in their conclusions. Economists at both Lehman Brothers (LEH) and Barclays Capital (BCS) have also argued that the slowdown in productivity and other factors will complicate Fed policy decisions. Until recently, economists generally believed strong productivity would allow the economy to sustain growth of a little better than 3% over the long run without pushing inflation higher. If so, then the current economic slowdown should be creating enough slack in the job markets and production capacity to ease pressure on costs and prices. That doesn't seem to be happening.
ASSUMING THE ECONOMY grows 2.5% in the first quarter, its pace over the past four quarters has dropped markedly, to 2.3%, from 3.7% the year before. If the economy were capable of sustaining 3% growth without boosting inflation, as was generally believed in recent years, then the unemployment rate would have risen by now. Instead, joblessness in February, at 4.5%, was 0.3 percentage points lower than it was a year ago.
Based on this and other labor market trends, economists at JPMorgan (JPM) estimate the economy's long-run noninflationary growth rate is now no higher than 2.5%, and it might be lower than that. Such a downshift would mean the economy would have to grow below that rate for a considerable period for inflationary pressures in the labor markets and the economy to ease enough to allow the policymakers' preferred inflation gauge to slip back into their 1% to 2% comfort zone.
The central bank has projected inflation will end the year in the range of 2% to 2.25%, before sliding below 2% in 2008. However, the rate in January was 2.3%. It has been at or above 2% for nearly three years, and the recent trend is up, not down. As of February, inflation measured by the core consumer price index also remains elevated, at 2.7%, held up by service prices.
The bottom line: The Fed may have to squeeze the economy harder than it has in the past to assure core inflation comes back into the policymakers' comfort zone. If inflation does not behave according to the central bank's optimistic expectations, the Fed could face a credibility problem on Wall Street. However, a tough stance against inflation could magnify the problems in housing and in the economy generally.
For investors, the implications of this changing economic landscape could be significant: Growth in corporate earnings may already have peaked, and rising labor costs may pinch profit margins, Plus, outside of a recession, the Fed would have less leeway to cut rates, and any rebound in the economy as the housing slump subsides might even be met with a new round of rate hikes. All this portends a much tougher investment climate in the years ahead.
By James C. Cooper