May 14, 2010

Employment rose 290 thousand in April which highlights the fact that the recovery is becoming broader and deeper.  The market has been waiting a year for jobs to materialize, and at last businesses are cooperating.  To some this sign of economic vigor suggests that the Fed will move quickly to reverse its low rate policy.  We disagree.

 The Fed is not opposed to growth per se.  What it seeks to prevent is excessive growth, which should be defined as growth of sufficient magnitude that it provides a threat to the Fed’s stated goal of price stability.  The last two quarters GDP has risen by 5.6% in the fourth quarter and 3.2% in the first.  That is reasonably impressive.  However, much of that growth has been attributable to inventory accumulation.  It is all well and good to boost inventories, but if firms can’t sell those goods, then ultimately production has to slow.  For that reason economists like to exclude inventories and focus on final sales.  It is a better measure of how quickly the economy is growing.  In the past two quarters sales growth has been much more modest at 1.7% and 1.6%, respectively – numbers that are hardly going to strike fear in the hearts of the folks at the Fed.

But what about inflation?  The Fed’s reason for being is to keep prices stable.  Shouldn’t we worry about that?  Eventually yes, but not now.

 In the past year consumer prices have risen 2.5%.  But look at how volatile that series is!  In July 2008 it was rising at a 5.5% pace, then during the recession prices declined by 2.0%.  Those swings are largely attributable to the rise and fall of energy prices.  To attain a better snapshot of the underlying rate of inflation, economists like to exclude the often volatile food and energy components.  This series is far smoother and is currently rising at a 1.2% rate.  Even more interesting is the fact that in the past five months, this core inflation rate has been unchanged.  Thus, in the months ahead this series will be headed even lower – towards zero — not higher.

 Why is that happening?  The answer lies in the combination of a very high unemployment rate, and extraordinary gains in productivity.  At 9.9% the unemployment rate is obviously very high.  Lots of workers are seeking every available job.  Not surprisingly this slack in the labor market is putting downward pressure on earnings.  In the past 12 months wages have risen 2.3% which compares to average wage growth of 4.5% in the first 8 years of this expansion.

Now let’s talk about productivity.  Suppose I pay you 10% higher wages.  At first blush you might think that my earnings would be sharply reduced, and that I would have to raise prices to offset the higher cost of labor.  But what if you were also 10% more productive?  What that means is that I am paying you 10% more money, but you are giving me 10% more goods to sell.  I really do not care.  The higher wages do not slash my earnings at all, nor do I have any incentive to raise prices.  So the best way of looking at wages is to adjust them for gains in productivity, and economists have a name for that concept.  It is called unit labor costs.

Over the past year, earnings have risen by 2.3%, but productivity in that same period of time has jumped by 6.2%.  As a result, unit labor costs have declined by almost 4.0%.  That is why there is no worry about an imminent rise in inflation.  Labor costs, which represent about two-thirds of a firm’s total cost, are actually declining.  It is no wonder that inflation is both low and getting slower, and that corporate profits and stock prices have been rising so rapidly.

 For the Fed there is no need to abandon its low interest rate pledge any time soon.  The pace of economic activity is moderate, and inflation is already low and continues to abate because of downward pressure on wages.  At this stage the Fed probably welcomes more rapid growth rather than fears it.

Stephen D. Slifer

NumberNomics

Charleston, SC