This Recovery

The Expansion Continues

By MICHAEL DARDA March 13, 2007; Page A23

The latest jobs report is further evidence that the doomsayers aren't right about the state of the U.S. economy. There were 97,000 new jobs last month and the unemployment rate was 4.5%. Moreover, the job-growth numbers for December and January were revised upward by 55,000.

No doubt the pessimists will hone in on the declines in the number of construction jobs and hours worked during the last month. But these appear largely to be temporary, weather-related blemishes. Job growth in the services sector, which accounts for 84% of total U.S. employment, continues to expand by about 170,000 per month -- exactly the average of the last 12 months.

As always, prosperity has its discontents. With profits and productivity strongly outperforming compensation for most of this cycle, many of the usual suspects have emerged to call for higher tax rates on upper earners, caps on executive pay and other "equalizing" measures. But history shows that profit and productivity cycles always revert to the mean, with compensation playing catch up as the demand for labor rises and unemployment rates fall.

How has the average worker fared during the current expansion compared to the 1990s boom? Real wage growth for non-supervisory workers has averaged 0.6% per year for the last 21 quarters, twice the pace of the same period during the 1991-2000 expansion. The broader measure of real labor compensation per hour has advanced at 1.4% per year during the last 21 quarters of consecutive growth, compared with a 0.6% annual average during the last recovery cycle.

The main explanation for the strong performance of wages is an unemployment rate that has averaged 5.4% during this expansion, compared to 6.4% during the comparable period of the previous cycle.

Some argue that the problems in the sub-prime mortgage market and manufacturing are only the beginning of a much broader and more intense slowdown that is likely to undermine the labor market and stifle consumption. While the problems in the sub-prime mortgage market shouldn't be taken lightly, mortgage resets are estimated at $10 billion to $15 billion during the next two years -- about 0.1% of nominal GDP and 0.02% of aggregate household net worth. Sub-prime borrowers are mostly households in the bottom 20% of the income distribution, which accounts for only about 8% of total consumption spending.

With broad measures of commercial bank credit and household deposits expanding at a 9.8% and 10.3% annual pace, respectively, and global foreign exchange reserves expanding at a 17% year-to-year pace, it hardly seems that a broad-based liquidity squeeze or credit crunch is on the horizon.

The Fed's 2007 forecast for about 2.75% real GDP and nominal growth of about 5.25% continues to look modest against the backdrop of still-massive global liquidity, low real interest rates, low tax rates on capital and a booming global economy. It is a little reported fact that exports added more to GDP growth last year than housing took away. If the drag from housing is removed, the U.S. economy expanded at nearly a 4% average annual rate in 2006. Even with the housing drag, full-year growth was slightly faster in 2006 than it was in 2005.

As the drags from housing and manufacturing abate sometime later in 2007, it is more likely than not that the economy will return to an above-trend growth rate powered by strong consumption (via a tight labor market), strong global growth (exports) and a pickup in capital spending (thanks to record profits and still-tight credit spreads).

Indeed, the current environment of excess liquidity and a super-tight labor market appears to be the first such combination since the 1960s, a period during which unemployment rates fell below 4%. The mid-1960s also witnessed an inverted yield curve, a sharp contraction in residential construction and a sharp, temporary slowdown in overall growth -- but no recession. Perhaps this was because financial conditions were moderate during this period, as they are today.

The unemployment rate dropped briefly below 4% at the tail end of the last economic expansion in 2000, but this period was characterized by excessive dollar strength, weak commodities, wide credit spreads and high real interest rates. Not surprisingly, profits were weak between 1997-2000 as tight financial conditions eviscerated corporate pricing power. In other words, there seem to be more differences than similarities between the current environment and the situation that existed at the end of the last cycle.

The Fed's assumption of about 2% core inflation for 2007 would appear to suggest that board members believe profit margins will compress significantly this year, as was the case during the late 1990s and early 2000s. The sanguine outlook for inflation seems to be justified by modest spreads in the inflation-linked bond market and "low and stable" survey expectations for inflation five years ahead.

The problem with the inflation-linked bond market and with various surveys of inflation expectations is that they tend to rise and fall with (or after) actual inflation, not before it. And to the extent that excess liquidity is holding interest rates below levels that would prevail under more normal conditions, the bond market may be giving policy makers a false sense of security about the inflation outlook.

With unit labor costs now rising at the fastest pace in six years against the backdrop of easy financial conditions, the risks appear to be skewed toward higher inflation rather than a weaker economy. Tight labor markets should continue to support consumption and growth, but corporate pricing power may also prove to be better than most analysts suspect.

In this scenario, non-energy inflation almost surely would fail to moderate as widely expected, and the batch of Fed rate cuts now priced into the bond market likely would be up in smoke once again.

Mr. Darda is chief economist for MKM Partners.

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