JUNE 2004

Job Growth Raises Inflation Fears

Strong employment growth statistics for May indicate vigorous growth in the U.S. economy. Over 248,000 jobs were created in May, more than many analysts had forecast. Nearly one million jobs have been added in the last 3 months. As of the end of May, weekly unemployment insurance claims were at their lowest level since 2000. The national unemployment rate is 5.6%, down from its cyclical peak of 6.3% in June of last year. The unemployment rate is down in 47 of the 50 states. Gross Domestic Product grew at a 4.2% annual rate (adjusted for inflation) during the 1st quarter of this year.

William C. Dunkelberg, Chief Economist for the National Federation of Independent Business, has found in member surveys that small business hiring and planned hiring is the strongest since 1999. He also notes that the recent political furor over "outsourcing" (i.e., the transfer of American jobs to call centers and other facilities overseas) will fade away as the employment numbers continue to improve. For those politicians that continue to press for federal legislation that would limit or penalize "outsourcing" by American companies, Dunkelberg reminds them that all of the $118 billion of U.S. imports of goods during March 2004 represents outsourcing to other countries. "Larger than the GDP of most countries, [annual] U.S. imports represent our purchases of goods made by foreign workers. There is nothing we buy from overseas that we couldn't make here, but that would interfere with the proven benefits that come from the pursuit of comparative advantage. And, few consumers will accept the higher prices that would result from bringing all that work back to the U.S.... If outsourcing is "bad," then it's time to stop importing."

Now that the economy is humming along, a shift in Federal Reserve policy toward higher interest rates seems inevitable. Economist William Dudley of Goldman Sachs expects 100 basis points of tightening by the end of this year, probably delivered in several small, 25 basis-point increments as the Fed tries to avoid spooking the financial markets. The good news is that he does not see a repeat of the tightening sequence experienced a decade ago (1994-1995) when the Fed raised rates by 300 basis points over a 12-month period. Factors are already in place today that will dampen consumer spending. The artificial boost to spending triggered by last year's tax cuts (much of which was reflected in unexpectedly large refunds delivered in the spring of 2004) will not repeat. Rising mortgage rates will dampen mortgage refinancing activity and home equity withdrawals that have boosted spending. Higher energy prices are putting pressure on household budgets.

Nevertheless, Dudley points out that the Fed cannot afford to ignore the recent rise in inflation expectations. An expectation of higher inflation prompts firms to attempt to raise prices, and workers to seek higher compensation. Both feed inflation, making expectations of higher inflation a self-fulfilling prophecy to some degree. So, a cautious tightening process will begin soon, possibly at the end of June.