Economic Growth, Labor Costs Fan Inflation Fears

Free-spending U.S. consumers and businesses spurred strong economic growth in the first three months of the year, but a bigger-than-expected jump in labor costs intensified concerns that the good times may finally be rolling out of control.

The gross domestic product grew at an annual rate of 5.4% from January through March, the Commerce Department reported Thursday. While less than the extraordinary 7.3% growth of late 1999, that was still more than an economy can normally sustain without inflation.

The bigger--and, for investors, more ominous--surprise was the Labor Department’s report that labor costs rose by 1.4% in the first quarter, significantly higher than the 0.9% consensus forecast of private economists.

Various pay and benefits increases took labor costs to a level 4.3% higher than in the first quarter of 1999. It was the biggest year-to-year gain since 1991.

“The Fed now has a smoking gun,” said Diane Swonk, chief economist at BankOne Corp. in Chicago, alluding to the proof of inflation that economists have been seeking for months but not finding.

Many private forecasters said they now expect the Federal Reserve’s rate-setting Open Market Committee to raise its key short-term interest rate, currently 6%, by half a percentage point when it meets May 16. The Fed has raised that rate five times since last June, but each time by only a quarter of a point.

“And they’re not done there,” Swonk predicted. “Those who are waiting for an end to Fed tightening are going to be disappointed. Once inflation gets into the labor markets, it feeds on itself and it’s very hard to get rid of.”

In response to the new data, long-term bond yields jumped, and the Dow Jones industrial average plunged by 200 points shortly after trading opened Thursday. But the Dow made up more than two-thirds of that decline before the close of trading and finished down 57.

Analysts focused on Fed Chairman Alan Greenspan’s repeated warnings that the U.S. economy presents dangerous imbalances that have to be corrected if the inflation-free expansion is to continue. In particular, Greenspan has emphasized the likelihood that America’s big stock market gains of recent years have prompted consumers to spend dangerously beyond the economy’s capacity to produce goods.

The first-quarter GDP figures contained little to allay such concerns. The decline from the fourth-quarter’s torrid growth rate, in fact, masked an acceleration of consumer demand during the first quarter. Consumer spending rose by an 8.3% annual rate from January through March, up from a 5.9% growth rate in the fourth quarter.

“Consumer spending is the danger number,” said Rajeev Dhawan, director of the UCLA Anderson School’s forecasting project. “The wealth from the stock markets has made people giddy. It looks like the Fed’s five rate hikes so far haven’t done anything to the consumption profile.”

Dhawan said he still expects just a quarter-point rate increase at the next Fed meeting, and one more quarter-point increase after that--but he said that is based on an assumption that the stock markets soon will undergo “a sustained correction.”

Another of the risks now on the Fed’s list is the low U.S. jobless rate, which raises the possibility that businesses will soon run out of qualified people to hire. Personnel managers would then have to start an inflationary round of bidding wars to poach the best people away from other firms.

Thursday’s labor-cost report convinced some analysts--though not all--that this process is already underway.

“The interesting question is, did wages go up because business had to bid for workers?” said Mark Vitner, an economist at First Union Securities Inc. in Charlotte, N.C. “Or did wages go up because workers were more productive?”

The uncertainty arises because most of the quarter’s biggest pay gains took place in the economy’s hottest sectors. Workers in financial services firms, for instance, now cost their employers 9.3% more than they did a year ago. That’s more than twice the increase for all other private-sector workers.

But the brokers and other financial professionals have been reaping commissions and bonuses from last year’s bull market, and that may be driving their gains, not a bidding war among employers.

Similarly, white-collar salespeople now cost their employers 6.7% more than a year ago. But their good fortune is, in large degree, the result of commissions on sales of houses, cars and other big-ticket consumer items--all of which have been setting sales records recently.

The labor-cost index does not measure the effect of productivity gains on the total cost of production faced by employers.

Until now, technology-driven gains in productivity have enabled firms to pay workers more without significantly raising prices to consumers. However, coming on the heels of a broad-based surge in consumer prices in March, Thursday’s number strengthened evidence that inflation is taking hold.

Vitner said it was impossible without more data to sort out the degree to which labor-cost bidding might be going on. Next Thursday’s productivity report, he said, will shed new light on that crucial question.