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ECONOMIC PERSPECTIVE
Prepared by Merrill Lynch & Co.
Global Securities Research & Economics Group
Growth May Trigger Uptick In Inflation
While growth slowed to 3.3% in the second quarter from 4.9% in the first quarter, the overall pace a bit above 4% is considered too fast to be sustained without triggering an uptick in inflation, Indeed as we have recently been writing, a combination of circumstances including the absence of a further decline in energy prices and the tightening of the labor market which occurred in the first half, is likely to result in a period of somewhat higher inflation over the next 6 to 12 months. However this should not overshadow the fact that the economy is still likely to grow at a healthy pace, and inflation will probably remain well below the 6.1% (5.2% core) level reached in 1990.
In general, we expect growth going forward to slow to a more manageable rate between 2 and 2.5%. Specifically, the third quarter is likely to be a transition quarter where growth is still near 3% as underlying consumer demand bounces to 3.7% from the sluggish 1% pace of the second quarter. However, inventories rose at what we think is an unsustainable pace in the first half, and both a slower inventory build and further deterioration of net exports due to the rising dollar will subtract from the still robust demand curbing second-half growth somewhat. If, as we forecast, the underlying consumer demand drops to the 2.5% level over the next few quarters, then growth is likely to average 2 to 2.5% into mid-1998.
Will Labor Market Tighten Further?
One of the open questions is whether the economy can grow at up to 2.5% without tightening the labor market further. We think it can. This business cycle has been disproportionately driven by capital expenditures, both in the U.S. and world-wide, and capacity is being added at a rate of 4% or more, which is well above the 2 to 3% level historically. With excess capacity emerging in Asia, restructuring continuing in some industries in the U.S., and productivity enhancement likely to continue at a rapid rate given the continuing “quantum” leaps forward in computer power and user friendliness, a slowdown in growth is likely to relieve labor market tightness over a period of time. Still, as indicated, the market may already have tightened sufficiently to result in a bit more inflation before that unwinding occurs.
The reason for expecting an uptick in inflation is that (1) food and energy prices are not likely to subtract from CPI as they did in the first half and (2) the labor market is tighter. In the first half, food and energy subtracted 0.9% from the 2.4% core inflation yielding a marginal rate of 1.5% and bringing the year-over-year rate down to 2.2%. While we do not look for a substantial rise in these components in the second half, the mere absence of a further fall would boost the overall marginal rate of inflation by about a percentage point bringing it closer to the core rate. In addition, the tightening of the labor market due to the high level of first half growth lowered the unemployment rate from 5.3% at the end of 1996, to 5.0% at the end of June. It has since dropped below 5% in the latest reading.
Demographics and structural changes in the economy have probably lowered the level of unemployment which can be sustained without triggering an inflationary rise in wages from the 6% plus trigger of the 1980's. However, inflation tends to be a lagging variable, and at some point the tightness in the labor market will result in a rising rate wage costs. Given the recent UPS settlement and the rise in the minimum wage, we would not be surprised to see a “dose” of higher wage growth, even if, as we forecast, the slowdown in growth going forward unwinds the wage pressures over the intermediate term.
One of the factors which may hold inflation down is the fact that in many industries, especially in the manufacturing sector, film production and hospital care where cost cutting restructuring continues, pricing power is non-existent, and the impact of rising wages would be to squeeze profits. Still, we would not be surprised to see the overall level of inflation rise to say, between 0.2 and 0.3% per month on average which is a marginal rate of near 3%. Since inflation rose at above 3% in the second half of 1996, the year-over-year rate of inflation may actually fall to 2.0% even as the marginal rate rises. However, as 1998 unfolds, the monthly numbers will be replacing those from the first half of 1997 and the year-over-year inflation rate is likely to rise from 2 to nearly 3% by mid-1998.
(Reprinted by permission. Copyright © 1997, Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
October 2, 1997David Horner
Merrill Lynch & Co.
Global Securities Research & Economics Group
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