Fool.com: Economic Freak Out (Fool Plate Special) August 6, 1999

FOOL PLATE SPECIAL
An Investment Opinion

Economic Freak Out

By Matt Richey (TMF Verve)
August 6, 1999

At 8:30 a.m. this morning, the financial markets pounced on the July employment report like a pack of starving hyenas. The ravenous creatures had been hoping for some weak prey, but one look at the strong economic data sent the pack fleeing, tails between their legs.

According to the BLS data, the unemployment rate was unchanged at 4.3%, a level that has been fairly steady since December of last year. Of greater interest to the markets, however, were the nonfarm payroll employment figures, which showed a monthly increase of 310,000, well ahead of the market's consensus estimate for 205,000. Stock index futures plummeted on the news, but over the course of the morning the major indices have improved somewhat, although volatility continues to be the story.

For Main Street U.S.A., this is great news. The American economy continues to produce a plethora of high-paying jobs in what will soon be a record ninth year of economic expansion. But for Wall Street, soaring economic prosperity is raising worries that overly hot output growth will give rise to inflationary pressures.

Rapid economic growth isn't a cause for concern if it is the result of productivity gains, but yesterday's productivity report showed deceleration in productivity and acceleration in unit labor costs. Productivity for the second quarter increased at a 1.3% sequential pace, falling short of the market's expectations for 2.1% growth. These numbers are causing many economists to grow increasingly concerned that economic growth is being fueled by higher labor costs rather than productivity gains.

One of those worried economists is Alan Greenspan. In G Money's recent Humphrey-Hawkins Testimony, the Fed Chairman issued the following warning that is now weighing heavily on the market:

"Should productivity fail to continue to accelerate and demand growth persist or strengthen, the economy could overheat.... One indication that inflation risks were rising would be a tendency for labor markets to tighten further."

So now in the past two days we've seen productivity fail to accelerate and a tightening of labor markets, according to the nonfarm payrolls number. The consensus on Wall Street is that the Fed will definitely tighten the Fed funds rate by 25 basis points (0.25%) at the next Federal Open Market Committee (FOMC) meeting later this month.

Arguably, the Fed is being overly vigilant in its efforts to curtail inflation. For the first half of this year, the core CPI (consumer price index) -- one of the primary gauges of inflation -- has advanced at only a 1.6% seasonally adjusted rate, down from 2.4% in all of 1998. In fact, looking at the core CPI number for the past five years shows a fairly steady trend of declining inflation:

Core CPI (excluding food and energy) -- Percentage change 12 months ended in December

1994     2.6%
1995     3.0%
1996     2.6%
1997     2.2%
1998     2.4%
1999*    1.6%
*first 6 months

Not only are we in a period of stable-to-declining prices, but the economy is certainly experiencing productivity gains above and beyond the government's reported figures. The government's historical productivity data shows conspicuously wide swings from quarter to quarter that seem inconsistent with how productivity would actually reveal itself in an economy. With the influx of computers, information technology, and the Internet, corporate profits are clearly thriving and showing no signs of restraint from rising labor costs. Already the S&P 500 is on pace to achieve 17% earnings growth for 1999, and 14.5% growth is expected for 2000.

With no clear signs of inflation in place, I hope the almost universally esteemed Fed Chairman doesn't take any actions that would unravel this unprecedented American prosperity.

Of course, for the long-term investor, much of this is a moot point. Over the long haul, interest rates will rise and fall, but through appropriate policy decisions the economy will do better more often than not, and long-term investors in stocks will reap the benefits.