Brakes go on as America runs out of workers

THE SUNDAY TIMES (LONDON)

November 21, 1999

Just in the nick of time. That is the most sensible reaction to the Federal Reserve Board's monetary policymakers' decision to raise interest rates last week. For had the Fed stayed its hand, it would been faced with the necessity of raising rates at its December 21 meeting, on the eve of the emergence of such Y2K problems as may be lurking in the banking and business communities, or holding off until early February.

That might have been too late to cool off an economy that is experiencing a serious labour shortage, with its inflationary implications for wages and prices. Recall that Greenspan and his colleagues cut rates three times -- by 0.25% in each case -- in response to the economic miseries that were afflicting Asia and Russia. Whether America's central bankers should have taken it upon themselves to save the world, rather than concentrate on the American economy, remains a subject of debate.

After all, it is arguable that the rate cuts had two effects that now worry the Fed. First, they helped to keep share prices higher than they would otherwise have been, adding to "the feel-good factor" that is putting bounce in the step of home builders and car salesmen. Second, by pushing up growth rates, the rate cuts exacerbated the labor shortage that last week was the major factor prompting the Fed to reverse the last of its save-Asia rate cuts.

That done, the Fed can't help noticing that the American economic locomotive is, if anything, picking up speed -- from a rate that it last week declared already to be "in excess of the economy's growth potential". On the same day as the Fed raised rates, several of America's retailers reported major increases in sales -- and even larger increases in earnings. Consumers continue to snap up attractively priced apparel and, in the case of Home Depot -- a chain of home improvement stores -- pricier merchandise such as Ralph Lauren paint. All in all, retail sales in October were 8.5% above last year's levels. As a result, and despite an increase in inventories, the inventory-to-sales ratio is at its lowest level since the government began compiling this revealing statistic in 1980.

Meanwhile, corporate profits remain at levels capable of sustaining the high level of business investment that has helped to maintain the 4-5% growth rate that now characterizes the economy. Business Week's tabulation of the profits of some 900 companies so far this year shows increases of 12% in the first quarter, 28% in the second quarter, and 24% in the third quarter. The latter figure is inflated somewhat by the fact that third-quarter 1998 was a poor period. But, eliminate one-time negatives in last year's third quarter, and you still get a profit jump of 16%. Not bad.

And the profits prospects for 2000 are just about as rosy. Analysts -- whose predictions have been just about on target this year -- are predicting a 16% rise in profits for the S&P 500 next year, which means that share prices are at about 22 times anticipated earnings -- high but not crazy. Or, in the more refined words of Coutts' Investment Perspective, "...corporate profits remain strong [and] valuations have reduced to more sustainable levels."

This profits outlook reflects the expectation that the economy will continue to move ahead at a rapid rate. Consumer confidence remains high, a reflection of the ready availability of jobs. Home construction is down a bit, but that seems to be due more to the inability of contractors to find workers than to a fall-off in demand. The index of automobile affordability, a measure compiled by Comerica Inc. to relate incomes to auto prices, continues to move in a favorable direction. In the third quarter of this year it took 23.4 weeks of earnings by a family at the median-income level to buy the average new car. That's down from 24.2 weeks one year ago -- a 3.3% improvement in affordability that bodes well for auto sales.

But there is a dark side to this story, and that is the labor market. Just about all of the couch potatoes that were available have been drawn into at least part-time work. Various reforms have driven those on the welfare rolls who are employable to abandon their handouts in favour of paychecks. Several firms report that they are now relying almost exclusively on immigrants and on previously unemployable disabled persons to fill jobs.

Under these circumstances, upward pressure on wages and fringe benefits is increasing. The big question is whether productivity, which in the last quarter rose at the robust annual rate of 4%, can keep pace as more and more marginal workers are drawn into the labor force.

The Fed thinks not. And it also thinks that the emerging recoveries in the world's economies will drive up the price of commodities and of the imports which, until now, have provided American consumers with cheap trainers, t-shirts and cars. If the 29-member Organization for Economic Cooperation and Development is right in raising its forecast of economic growth in the industrialized countries in 2000 to 3.5%, the Fed may have reason to worry. And to continue worrying until it next meets.

So last week's rise, which most analysts are saying will be the last for some time, may well be the precursor of more to come, perhaps as early as February. The Fed seems to have satisfied itself that it has done its duty by the rest of world, and can once again concentrate on America.

My own guess is that if labor markets remain tight, if recovery takes hold in other key economies, and if the OPEC oil cartel maintains the supply restrictions that have resulted in a more-than-doubling of crude prices, we will not have seen the last interest rate increase -- even if the usual inflation indicators fail to flash red.