Forget What You've Heard: Inflation Looks to Go Lower, Not Higher

A. GARY SHILLING is president of A. Gary Shilling & Co., economic consultants and investment advisers based in New Jersey

Is inflation about to rear its ugly head in the United States? Many believe so after the recent spurt in commodity prices, especially gold and silver.

These worries over commodity-driven inflation have caused bond investors to gloomily recall the inflation-laden 1970s, when not only did bond prices decline as interest rates rose, but those rising yields, when adjusted for inflation, were distinctly negative. Even the ever-careful Federal Reserve Chairman Alan Greenspan has hinted that inflation could be waiting in the wings--and the Fed is fully prepared to keep it there.

But are commodities really the driving force of inflation? I don't think so. The only, and I mean only, time in the postwar era that commodity price hikes generated general inflation was in the early 1970s--when shortages appeared to have become a fact of life and the oil embargo wreaked economic havoc. Nevertheless, inflation would not have become economy-wide without the cooperation of American business people.

As inflation, particularly of commodities, drained purchasing power from employees, most corporate leaders--feeling duty bound to keep employees at least abreast of inflation--granted offsetting pay increases. When inflation became embedded in labor compensation--which accounts for three-quarters of the total cost of doing business--it also became embedded in the economy as prices chased wages, which chased prices, in a vicious spiral.

But with the exception of that period, the correlation between commodity price fluctuations and inflation has been limited. Inflation actually correlates much better with increases in labor compensation. Here, their close relationship doesn't exist only in the early 1970s, but throughout the postwar era.

But there's more to this. It isn't labor compensation alone that pushes prices; it's labor costs after being offset by gains in productivity. In other words, if output per hour worked rises, say, 3% a year, wages can rise 3% without putting any pressure on prices. If, however, productivity growth is zero, the full effect of wage increases flows through to prices. Thus, the growth in "unit labor cost," which is the ratio of labor compensation per hour to output per hour, is quite closely linked to the growth of inflation.

But recently in the United States, unit labor cost and inflation growth (as measured by the consumer price index, or CPI) have diverged. In the last quarter of 1992, year over year unit labor cost rose only 0.4%, while the CPI was up 3.1%. In fact, unit labor cost fell 0.4% in the last quarter of 1992 compared to the third quarter.

Something has to give to realign these two measures, and it's more likely that inflation will fall than that unit labor cost will jump. Why? Because not only are U.S. manufacturers continuing their decade-long zeal for productivity improvement, they now are being joined by the huge service sector, where 77% of Americans work.

Pressed by stringent foreign and domestic competition, consolidation in deregulation's aftermath, bad debts and an inability to raise prices in today's economic climate, American business has no other choice. Furthermore, the ongoing technique for productivity improvement--layoffs and job eliminations--curtails unit labor cost by minimizing the wage demands of those lucky enough to still have jobs. And labor compensation is being further depressed as businesses replace workers with machines, converts expensive full-time employees to fringeless temporary or contract workers and eliminates well-paid middle managers. And don't forget the obvious effects of actual pay cuts in airlines and other distressed industries.

Furthermore, the growth in consumer prices as reported by the CPI numbers is probably overstated. The CPI represents a fixed "basket of goods" that is revised only every five years or so--and so misses out on important trends. For instance, the CPI does not take into account the introduction of popular items such as CD players or video cameras that often attract a lot of spending and decline rapidly in price. Nor does it record the tendency of people to spend more on items that are falling in price--such as personal computers--and less on those that are inflating rapidly, such as upscale restaurant meals.

Of course, if the degree of overstatement of inflation by the CPI is consistent through time, it doesn't make a lot of difference. Bond yields, cost-of-living escalators, etc., simply adjust to this steady overstatement of actual inflation. It's different, however, if the overstatement is changing, as it undoubtedly is now. U.S. consumers, pressed by huge debt levels, actual and threatened layoffs and the realization that their biggest asset--their home--is no longer a great investment, are doing anything to save a buck.

One effect of consumer cost-consciousness has been the recent well-publicized stampede away from expensive name brands into generics, prompting amazing price cuts by industry leaders, such as Philip Morris' Marlboro cigarettes. The tobacco companies and governments that tax them assumed--correctly in past years--that prices and taxes could be raised with abandon without scaring confirmed smokers away. Not any more!

The CPI does not reflect this huge shift to generics and house brands, either. Altogether, the degrees of overstatement in the CPI relative to the past is hard to measure, but it wouldn't surprise me if it equaled as much as one percentage point of the reported CPI growth. In other words, consumer inflation may be running closer to 2% a year than 3%.

Market forces, then, argue for much lower inflation--deflation, to be precise. But there are caveats. One is the worry many have about the falling dollar and its effect on import and export prices. But the whole world is in recession or slow growth to one degree or another.

Producers in every major country are under the gun to spur productivity and cut labor costs in order to compete globally. The last thing they want to do is lose American market share because of a weak dollar. Consequently, foreign exporters will cut their costs and profit margins and shift production to lower-cost areas to avoid raising their prices in dollar terms.

And I continue to believe that the rise in the dollar that started last summer will continue, as investors realize that the U.S. economy, in this recessionary world, is still the best of a bad lot.

One last caveat: President Clinton. The White House is controlled by a crowd that believes in government "management" and "investment." Translated, that means protectionism, expensive regulation and inefficient spending. I don't think they'll be able to muck things up enough to rekindle inflation--especially given Clinton's plummeting approval rating and his defeat over his fiscal stimulus package. But they sure will try.

The bottom line: With universal zeal for productivity--especially aimed at eliminating labor cost--deflation and lower interest rates are in store in the United States. Hang onto your bonds!

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