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Federal Reserve policymakers breathed a little easier after their meeting on May 9. At their previous get-together in March, worries about both economic growth and inflation seemed to have increased: The economy looked decidedly softer, even as prices continued to pick up. Those risks haven't gone away, but according to the most recent data, both concerns have ebbed somewhat. Fresh signs suggest growth was on somewhat firmer footing at the start of the second quarter, while inflation pressures have eased a bit. That combination helped make the Fed's choice to keep its target interest rate at 5.25% an easy one.
In the second half of the year, though, the central bank's rate decisions promise to be a lot more difficult. The only thing Fed watchers agree on right now is that policymakers will stay the course for a while longer. After that, opinions diverge sharply between those analysts who expect the Fed to start cutting rates and those who think the next move will be to hike.
At the heart of this divide is the apparent disconnect between the economy and the labor markets. The economy has slowed significantly, but the job market remains tighter now than it was before the slowdown began. The economy's four-quarter growth rate has fallen to 2.1%, from 3.7% this time last year, but the unemployment rate, at 4.5% in April, remains a shade below its year-ago level.
It's not supposed to happen that way. By now, slower growth should have caused the labor markets to loosen up a little, reassuring the Fed that inflation will remain under control. Last summer, Fed officials expected the economy to grow at a rate of 3.25% to 3.5% and unemployment to end the year at 4.75% to 5%. Growth actually slowed more than that, but the jobless rate still fell below the projection. So far in 2007, the Fed's favored inflation measure continues to hover above the top limit of its 1%-to-2% comfort zone.IN THE MARKETS, the camp anticipating rate cuts says the lags are just unusually long this time, that the weakness in housing will extend to consumer demand and ultimately create some slack in the labor markets, allowing inflation to decline and the Fed to ease policy. The hikers, however, think the direct effects on the economy from housing have about run their course, that the indirect effects on consumers from weaker home prices and less cash from their home equity are minimal, and that the rest of the economy is still doing fine. That scenario would keep labor markets tight and price pressures strong.
The dilemma for both the Fed and investors, especially those clinging to hopes for lower rates, is this: The Fed under Chairman Ben S. Bernanke is still establishing its credentials in the markets as an inflation fighter. As long as inflation is a threat, it cannot cut rates unless softer labor markets give it a credible reason to do so. If the job markets stay hot, it might even have to lift rates. So for investors trying to divine where policy is headed, it's clear which signpost will be the most important over the next several months. The question "Whither the Fed?" boils down to "Whither the labor markets?"BUT THE MORE IMPORTANT issue for Fed policy and the economy is how this puzzle—slower economic growth with no letup in labor-market tightness—will eventually play out. Analysts, both within the Fed and on Wall Street, generally offer three possibilities.The most optimistic explanation is that because of the unique nature of the slowdown, which has been driven almost exclusively by the housing slump, the downdraft is taking an unusually long time to work its way through the economy and the job markets. Also, given the general shortage of highly skilled workers, companies are holding on to employees as long as they can to avoid the costs of firing and rehiring. Eventually, the scenario goes, hiring will slow, clearing up the paradox and perhaps allowing the Fed to cut rates.
But there is another, darker possibility: that the recent slowdown in productivity might be a permanent reversal from the speedup that began in the 1990s. The top concern is that business investment in the U.S. over the past few years has been anemic relative to the economy's strength. As a result, workers would become less efficient.
Worker productivity increased at an annual rate of 1.7% in the first quarter. In recent quarters the yearly growth rate in efficiency, currently at 1.1%, has fallen to numbers not seen in a decade, not even during the 2001 recession. A lasting slowdown in productivity would mean the economy would have to grow at a much slower rate than previously thought to loosen up the labor markets enough to keep inflation under control.
There is also a third possibility: Maybe the economy is growing faster than the data on real gross domestic product say it is. Real GDP is up 2.1% from the past year, but real gross domestic income, which in theory is the equivalent of real GDP, grew 3.8% through the end of last year. If the stronger income measure is closer to the truth, that would relieve some of the worries about weaker productivity growth and inflation pressures.THE LABOR DEPT.'S April employment report did little to resolve the disconnect between slower growth and tight labor markets. Business payrolls did show some cooling, rising by a slim 88,000 workers in April. Through this year's weather-related ups and downs, job gains have averaged 129,000 per month, down from 189,000 during all of last year.
But most economists agree the recent pace is still fast enough to hold the jobless rate steady at its current, very low level. The uptick in the April jobless rate, from 4.4% to 4.5%, fully reflected a big rise in teenage unemployment, while adult joblessness remained at a five-year low of 3.9%. And while the hourly pay of production workers grew more slowly in April, job markets have already proven they are tight enough to maintain the upward pressure on wage growth.It's not clear that more job market slack lies ahead, because other recent data suggest the economy is picking up again after its tepid 1.3% growth rate in the first quarter. A renewed decline in the trend of weekly claims for unemployment insurance heading into May suggests job markets remain strong.
Consumer spending is getting hit by the latest rise in gas prices, but other areas of the economy that were weak last quarter are looking stronger this quarter. The purchasing managers surveys for April showed business activity rebounding. Gains in factory orders and output indicate a pickup in business spending on equipment and a waning drag from top-heavy inventories. Overseas support for U.S. growth, meanwhile, remains solid.
Until questions about the job markets are resolved, the Fed will have to remain attentive to the risks of both a weak economy and higher inflation. In the meantime, the Labor Dept.'s monthly employment report will take on heightened significance among market players. To be sure, the Fed will be giving it very close scrutiny. By James C. Cooper