The Economy -- On The Comeback Trail

Dec. 21, 2004
Wage gains and economic recovery raise the specter of higher inflation.

Apparently no one can predict the future, including, but not limited to, bond traders. However, they have a better track record predicting inflation than I do. Thus, when the Treasury yield spread widens to over 2 percentage points, and when the long Treasury bond has backed up almost a full percentage point even as the Fed has repeatedly cut the funds rate, it would be folly to ignore this development -- particularly in view of the burgeoning budget surplus and the accompanying decline in the number of long bonds outstanding. That leads to one of the following conclusions:

  • Higher inflation is coming back, and will rise to the 3.5% to 4% range over the next year.
  • Higher inflation isn't really coming back, but traders are worried that Fed Chairman Alan Greenspan is overstimulating the economy by cutting the funds rate too far. To keep the inflation wolves away from the door, Greenspan will have to tighten fairly soon after he finishes easing, in which case the bonds are just a bit ahead of the game.
  • Inflation isn't coming back right away, but the budget surplus will melt away, which eventually will either boost financing requirements or lead to higher inflation. From 1997 through 1999 the core rate of inflation rose an average of 2.2% per year. It rose 2.6% last year, and has increased at an annual rate of 3.0% the last six months. An increase to 3.5% to 4% next year is the most likely outcome. The inflation bulls, i.e., those who think low inflation will continue indefinitely, claim that wage gains are unlikely to accelerate during a period of rising unemployment, and they assume firms will be unable to boost prices on internationally traded goods and services because of vigorous foreign competition. However, I find several compelling counterarguments:
  • Wages invariably lag changes in employment on both the upside and the downside. It is the rule rather than the exception that wage rates rise faster during recessions than during the last year of the previous boom.
  • Cost-of-living increases are based on the actual consumer price index, which has risen at a 3.8% annual rate so far this year. The Fed may disregard higher gasoline prices and utility bills, but most consumers don't.
  • Higher oil prices affect worldwide production, so they are more likely to be passed along in the form of higher prices even with continued vigorous foreign competition.
  • Pension benefit contributions will have to pick up again now that firms are no longer getting a "free ride," courtesy of a booming stock market.
  • Medical-care costs will continue to accelerate. So far this year they have risen at a 6% annual rate, as shortages of nurses and other medical-care personnel abound.
  • In some industries, the sharp decline in profits will cause firms to raise prices despite competitive pressures, or go bankrupt.
  • Massive slashes in capital-spending budgets mean slower growth in productivity. Over the longer term productivity will not rise more than 2% per year.
  • Over the last few years many employees received stock options in lieu of higher wages and salaries. With many high-tech stocks still on the floor, this method of payment is less attractive. Consequently, heftier gains in wage rates are likely. In this respect, note that average hourly compensation as measured in the productivity release from the Bureau of Labor Statistics rose a measly 2.0% per year from 1993 through 1997, but then jumped to annual gains of 5%, 4.5%, and 4.8% in 1998 through 2000. Furthermore, it has risen 6% over the last four quarters. Initially, these large wage gains caused profits to nose dive. However, as firms regain their footing and the economy starts to recover, higher inflation will result. If average hourly compensation continues to rise 6% and the long-term productivity growth rate is 2%, that is consistent with a 4% rate of inflation. Even if the gain is 3.5% next year, that still is up substantially from the surprisingly low rates of the late 1990s. Prepare for higher inflation. Michael K. Evans is president of the Evans Group, an economics consulting firm in Boca Raton, Fla.
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