Big Profits May Hold Line on Inflation

Soaring corporate profits have stood out in an economic expansion marked by lackluster job and wage growth. Now those profits might be the Federal Reserve’s secret weapon when it meets today to consider a pause in its two-year campaign to raise interest rates.

Recent developments have left the Fed unhappily contemplating both creeping inflation and slowing economic growth. Ordinarily, measures designed to improve one aggravate the other.

Higher interest rates tamp down inflation, but at the cost of undercutting growth. Lower rates nurture economic activity but risk inflation.

Today’s robust corporate balance sheets -- after several years of record profits -- provide a cushion against the ill effects of rate increases. Companies can dig into their own pockets and finance expansion without worrying about paying higher interest rates for needed capital.

At the same time, healthy corporate profits mitigate the risk that workers’ demands for higher pay will lead to higher prices. Ordinarily companies have to meet wage demands by raising prices. Their stashes of cash should enable at least some of them to dig into their reserves instead.

“The Fed’s greatest fear is a wage-price spiral,” said Ed McKelvey, an economist with Goldman Sachs. “When companies are sitting on a fair amount of cash, they can absorb labor costs without raising prices.”

There’s no denying they have a fair amount of cash. Corporate cash and short-term securities held by industrial companies in the S&P; 500 index now total $633 billion, an “unprecedented” 62 weeks of net income, said Howard Silverblatt, a senior analyst for Standard & Poor’s.

When companies aren’t using their cash to pay high executive salaries, Silverblatt said, they are buying back their own shares. Corporations are also using the cash to buy one another, as demonstrated by the pickup in merger and acquisition activity.

Where did all this cash come from? Global competition had forced U.S. businesses to pursue cost-cutting efficiencies that led to bigger bottom lines, Bernard Baumohl, executive director of the Economic Outlook Group in Princeton Junction, N.J., said. And workers have little leverage to demand better wages at the start of a recovery, when unemployment remains high and labor markets are soft.

The combination of the corporate scandals of recent years and the 2001 terrorist attacks made companies very conservative with their spending, Ethan Harris, chief economist with Lehman Bros., said.

“Average consumers look like they’ve been at a party for the last 10 years,” Harris said. “That’s the negative story. The good news is that the corporate sector is flush with savings. In the last two years, corporations have come out of hibernation and started to buy new equipment and [buildings]. But they’re still very conservative, buying back stock and holding cash.”

All that cash makes it harder for the Fed to slow corporate outlays by raising interest rates. Consumers, who have been spending more than they earn for more than a year, are rate-sensitive. But businesses are immune as long as they can finance their own expansion.

If the Fed wants to bump interest rates one more time in its determination to fight inflation, it can find plenty of justifications. At the top of the list, the price index for core personal consumption expenditures -- everything that people buy except food and energy, the prices of which tend to swing erratically -- rose 2.4% in the 12 months ended in June. That’s uncomfortably above the Fed’s informal “comfort zone” of 1% to 2%.

What’s more, economists expect the Labor Department to announce today a sharp rise in unit labor costs -- what businesses pay workers for a given amount of output -- for the first three months of the year. The initial estimate was a mere 0.3% year-over-year increase; McKelvey looks for today’s updated estimate to soar above 3%.

The initial take on unit labor costs for the second quarter will also be announced. Analysts are looking for growth of 3.7%.

It’s not only Exxon Mobil that has earned massive profits -- $10 billion or so every three months, a corporate record -- since Hurricane Katrina struck nearly a year ago. After expenses, U.S. companies raked in cash at an annual rate of $1.5 trillion in the first three months of this year, according to the Commerce Department. That’s an increase of one-third just since 2003.

Looked at another way, inflation-adjusted labor costs have been just about flat since the end of the recession in 2001, according to Josh Bivens, an economist with the liberal Economic Policy Institute. Corporate profits, however, have doubled.