Is inflation finally back?
A growing number of economic indicators suggest it just might be
NEW YORK (CNNfn) - For the better part of the 1990s, inflation has been the Loch Ness monster of financial markets. Everyone knew it was lurking out there but no one had ever spotted it.
Until Thursday, when U.S. financial markets got one of their first confirmed sightings of the beast.
The Labor Department said wages and benefits grew 1.1 percent in the second quarter, higher than the 0.8 percent gain analysts had expected and well above the 0.4 percent increase posted in the first quarter. And gross domestic product grew at a 2.3 percent annual rate, putting the economy on track for a record expansion through the new year.
It was the largest quarterly gain since a 1.2 percent rise in the second quarter of 1991.
The numbers sent stock and bond investors paddling for the shoreline on the premise that the Federal Reserve will have to raise interest rates again to slow the economy and wrestle down inflationary pressures. The Dow Jones industrial average tumbled and bond yields soared on the news.
The Fed last raised rates a quarter point at the conclusion of its June 29-30 policy meeting.
"This is (Fed Chairman Alan) Greenspan's pet
number, and no one likes to be bitten by their pets," said Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, N.Y. "It seems likely that these numbers will be seen as significantly increasing the chance of an August rate hike."
Did you get it on tape?
Indeed, Greenspan is known to be a fan of the ECI report, which is released quarterly by the Labor Department and analyzes exactly what U.S. businesses are spending on wages, salaries and compensation for their employees. Wage costs typically account for about two-thirds of the average business' expenses.
But was it really Nessie? And does she really bite?
For months, analysts and investors have warned that the economy's performance has been too good to be true.
Economic growth has averaged close to 4 percent in the last three years with a definite tendency to the upside. Inflation, by contrast, has fallen to an average of about 2 percent this year from close to 3 percent in 1996.
Consumers, whose spending accounts for two-thirds of economic growth, have been picking store shelves clean at a frenetic pace. They've been writing checks for new homes, new cars, new appliances and fancy vacations.
And they've been buying investments at a dizzying pace. The Dow Jones industrial average has climbed more than 1,800 points this year; just as it surpassed the 10,000-mark in mid-April, it whizzed past the 11,000-mark in May.
"What everyone was wondering was where consumers were getting the money to pay for these things, and I do believe we got part of that answer today," said David Greenlaw, chief U.S. fixed income economist at Morgan Stanley Dean Witter in New York.
Inflation monster rears its head
Greenspan, too, had been awaiting arrival of wage inflation with trepidation. Back in May, the Fed chief warned that the nation's unemployment rate, in his opinion, could not rest at a record low forever without triggering some kind of pick-up in inflation.
"At some point, labor market conditions can become so tight that the rise in nominal wages will start increasingly outpacing the gains in labor productivity, and prices inevitably will then begin to accelerate," Greenspan told a Fed conference on banking in Chicago.
The Fed chief most recently warned in semi-annual testimony to Congress this week that, while advances in technology have helped boost productivity to unprecedented levels during the 1990s, an ever-tighter supply of labor would inevitably push up wages.
Poised for a slowdown?
Some evidence of late has suggested the U.S. economy is poised to slow. Aside from showing a slowdown in economic output in the second quarter, Thursday's GDP report indicated businesses expanded their inventories by only $19.4 billion in the second quarter, half the first quarter's $38.7-billion addition and down from a $44.2-billion increase in the final quarter last year.
While that could mean companies are anticipating strong demand in the third quarter of the year, it also could indicate that current demand for their goods isn't as robust, prompting much of their goods to head back to warehouse shelves, analysts said.
What's more, few anticipate the country's historically low unemployment rate will remain below the 4.2-percent mark for long. Downsizing at companies like Compaq Computer Corp. (CPQ) and Procter & Gamble Corp. (PG) will mean fewer workers and more job seekers.
Even Thursday's report held evidence that things aren't all doom and gloom. The first-quarter gain was the smallest since the government started tracking the statistics in 1982. And taken together, the two quarters average a 0.8 percent increase -- in line with the average 0.8 percent quarterly gain for the past three years -- a period in which inflation fell to its lowest in more than a decade.
A booming manufacturing sector
Nonetheless, the economy may not slow quickly enough to avoid a surge in inflation -- something the Fed wants to avoid at all costs. The housing market is still robust, retail sales are strong and the manufacturing sector -- one of the mainstays of the economy -- is showing renewed signs of strength as demand in Europe and Asia recovers, Greenlaw and other analysts said.
That was evident in the trade numbers, which indicated that the U.S. is sucking in goods, services and investment at a much more rapid pace than its shipping it out. Based on the formula used to calculate GDP, a lower trade deficit has the effect of boosting overall growth, while a greater shortfall subtracts from growth.
Analysts and investors will be watching economic reports closely in the coming weeks for more evidence one way or the other that inflation may be a problem. For some analysts, though, the current spate of numbers will be more than enough to convince Fed policy makers to raise rates again in August.
"If the Fed has a bit of an itchy trigger finger, the ECI headline number gives them the excuse to go sooner rather than later," Greenlaw said. "It does increase the odds of a tightening on Aug. 24."