The good news about the economy is that, buoyed by strong consumer spending and housing, real growth will return to the 4%-to-5% range by midyear. The bad news is that this will bring about double-digit growth in the money supply, higher inflation and higher interest rates.
While the decline in growth from 13% to 4% in the consumer price index during 1981 and 1982 was quite unexpected by economists, it is easy in retrospect to identify the factors that caused this decline. The stability and then decline in oil prices reduced inflation by 3%; so did the strengthening of the dollar. Productivity reduced inflation another 2%, and the decline in interest rates (which used to be included in the consumer price index) also took about another 2% off. In addition, the disinflationary effects of both tight monetary policy and the recession, the more pliant attitude of labor because of foreign competition and the lower wage gains because of the personal income tax rate cuts all reduced inflation as well.
However, we cannot escape the sad reality that none of these factors is still in place. Energy prices have now started to rise, and, while they may back off in the summer, we have seen them bottom at $27 per barrel. The dollar is in the process of declining perhaps 20% over the next three years; the peak values reached in March will hold over the remainder of this business cycle. Productivity gains have once again become anemic. Interest rates certainly will not fall further before the next recession; in fact, they are expected to rise as much as 2% by mid-1986, although this has a much smaller effect on inflation as measured by the consumer price index since the mortgage rate was removed from that index.
Inflation Will Rise
Finally, with the unemployment rate on its way down to 7%, the slight decline in the dollar and a further improvement in profits this year, labor will be less likely to accept a cut in real wages for the third year in a row. In many cases, employees will not have another tax cut to cushion this decline. As a result, inflation will rise from its recent level of 4% to 6% by year-end.
While the dollar may rally slightly in the next few weeks, it will be 5% to 10% below current levels by year-end for several reasons:
First, foreign investors now realize that the growth of the U.S. economy for the remainder of this business cycle will be more moderate, and hence investment opportunities in the private sector will not be quite as profitable as before. Any tax increase legislated this year would simply add to that feeling.
Second, economic growth in Europe has recently improved. While it was clearly in the doldrums in 1982 and 1983, recent forecasts show some signs of life on the Continent for this year and next.
Third, while interest rates will be rising in the United States, so will inflation, and hence the real rate of return will remain unchanged. More importantly, the rise in interest and inflation rates means that bond prices will decline, and hence the total return--yield plus capital gains--will diminish sharply. For all of these reasons, foreign investors have already started to diversify their portfolios by lightening up on dollar-denominated investments.
Oil prices are likely to mirror the behavior of the dollar. The stated capacity of the Organization of Petroleum Exporting Countries is so far above current production levels that, even if the world economy were to double its overall growth rate and if the conservation ethic were somehow to be tossed to the winds, the demand/supply balance would not affect oil prices for at least five--and probably 10--years.
Tighter Grip on Oil Prices
This had led some forecasters to predict that oil prices will continue to head down. Yet by permitting--perhaps even encouraging--prices to drop to current levels, the Saudis have essentially accomplished their aims of (a) discouraging alternative sources of supply, (b) blunting any further advancement of the conservation ethic and (c) showing they were capable of ruining the petroleum industry and much of banking in this country by pushing prices even lower. Now they have withdrawn from the brink, and prices will again be more tightly controlled.
With the dollar declining, OPEC will raise its prices at least in tandem with inflation in order not to suffer another loss of real purchasing power. This would be the reverse of what happened in 1974-78, when the rate of inflation rose so much that the relative price of gasoline and fuel oil in 1978 was hardly higher than in it was in 1973. It didn’t happen the second time; the alternative chosen then was a worldwide recession. The third time around, OPEC will try to keep prices steady in real terms instead of permitting those tremendous jolts to the world energy situation that are both economically and politically unnerving. If they plan to double the price of oil every decade, it is far better to accomplish this goal by raising the price 7% every year rather than boosting it 100% all at once.
Anemic Growth in Productivity
The final factor that will push inflation higher this year is the anemic growth in productivity. After a promising start at the beginning of this cycle, the underlying rate of productivity growth has once again declined to 1%. Indeed, in both the overall economy and the manufacturing sector, the rise in productivity in the current cycle is smaller than in any of the four complete previous cycles during the first nine quarters of recovery.
In the manufacturing sector, the cause of sluggish productivity growth is clear enough: lack of capital spending in industrial plant and equipment. In constant dollars, investment in industrial producers’ durable equipment fell from $47.4 billion in 1981 to $41.9 billion in 1984, while the percentage decline in industrial plant was even bigger, dropping from $18.9 billion to $14.2 billion (these figures also include agriculture and mining).
The lack of modern plant and equipment has critically hampered the drive for greater productivity despite the determined effort by both labor and management to increase output per employee hour.
Outside of manufacturing, the major question is why employment gains are so large. Of course, no one is against big gains in employment; one of the major accomplishments of the Reagan Administration is the tremendous number of jobs created in this country over the past three years, particularly when compared to the rest of the world.
However, the much-hoped-for breakthrough in the service sector, where the wizardry of computers was to have reduced staff time, appears to be one of those popular fictions--similar to the notion that labor and management have worked together in the manufacturing sector to become much more efficient, or the conclusion that new methods of inventory management and control have spurred productivity.
It is a far cry from today’s 1% growth in productivity to the 3% gains that existed during the 1950s and first half of the 1960s. Furthermore, the most recent statistics on labor costs are also not very appealing, as unit labor costs rose 7.3% last quarter. Part of this is the flip side of the 1.2% decline in productivity, but even without this gain, average hourly compensation costs rose at a 6% annual rate--about double that of last year.
Wage gains are also likely to accelerate this year. The real wage--the increase in earnings adjusted for inflation--actually fell during 1983 and 1984 for the first time ever during a period of economic prosperity. Wage gains will be somewhat larger this year, particularly in the non-unionized sector, and wages should increase 5% this year, compared to only 3.3% last year.
When the continually rising cost of fringe benefits is added and a mere 1% is subtracted for the gain in productivity, unit labor costs will increase about 4.5% this year, compared to less than 1.5% last year. The increase in the manufacturing sector is likely to be about 3% this year, compared to only 0.1% last year.
The combination of higher unit labor costs, coupled with the weakening dollar and higher energy prices, can point in only one direction--higher inflation. As a result, bond prices will fall proportionately and any further decline in interest rates will be postponed until the next recession.