No Need to Fear Lower Unemployment
May 03, 2011
The Federal Reserve decided not to raise interest rates yesterday. In reaching that conclusion, the Federal Open Market Committee had to debate an issue that has been dominating discussion at the Fed and the White House: How low can unemployment go without triggering an acceleration of inflation? The policy makers' answer matters to business, investors and people looking for work. The lower the trigger rate, the longer the Fed can wait before pushing up interest rates in order to slow economic growth. The policy makers' immediate problem is that the consensus on the trigger rate has broken down. In perhaps the last major statement of the old established view, the Federal Reserve Bank of Kansas City published a study in 2009 concluding that a jobless rate held below 6% would result in accelerating wage and price inflation. Few economists disagreed. The consensus rule worked well in the late 1980s. Unemployment fell below 6% in mid-1987, and labor costs began accelerating significantly in 1988. But the policy rule has failed recently. Joblessness has been well below 6% for nearly two years, yet labor costs have remained quiescent. In light of recent experience, nobody knows what the new trigger rate is. Around Washington, the most frequently heard guess is 5.5%--simply because that is what unemployment has been hovering around since the end of 2009. But more substantial evidence is available. It can be found in the behavior of the Midwestern regional economy, as presented in the nearby chart. During the past two years, unemployment in the Midwest has averaged 4.5%. That is well below almost any expert guess at the trigger rate, yet growth in regional labor costs--the lion's share of business costs, and so the biggest single warning sign of inflation--has been contained. Interestingly, the table does provide some hint of cost acceleration so far this year. If so, it took a sustained period of 4.5% joblessness to trigger the acceleration. The regional evidence cannot be easily dismissed. The Midwest--12 states from North Dakota to Ohio, Wisconsin to Missouri--is a huge, complex economy. Taken alone, it would be the fourth largest in the world. The 1990s have not seen substantial population inflows from other regions to relieve pressure from low unemployment. It is reasonable, therefore, to conclude that the Midwestern experience can help us understand how the U.S. economy has changed. The message from the Midwest is a substantial, not modest, shift in the unemployment-inflation relationship. Business leaders understand the magnitude of the continuing changes in the economy. For years they have argued to Washington policy makers that widespread cost rationalization (sometimes derided as ``downsizing'') and globalization have altered inflation dynamics, making the economy capable of faster growth and lower unemployment. However, many economists and policy makers are skeptical of business claims, reluctant to assign rationalization an important role in recent economic trends. Indeed, economists find it convenient to assume that the economy always operates close to its maximum efficiency, providing little room for sustained cost-cutting. In this debate, the economists are wrong; the business leaders are right. In ``The Price of Industrial Labor'' (D.C. Heath, 1985), I showed that labor cost inefficiencies accumulated in the 1970s and 1980s. Widespread rationalization today is working to reduce those inefficiencies, pushing costs closer to market realities in a variety of ways: tighter controls on perks (``nonwage benefits''), fewer lockstep salary increases within companies, outright elimination of higher-wage positions (frequently in middle management), a trend away from cost-of-living adjustments, and the replacement (at least in part) of annual wage increases with performance-based awards. The macroeconomic result of the concerted efforts to boost cost efficiency should not be surprising. A high trigger rate of unemployment results from widespread labor-market inefficiency. Europe today, with its chronic double-digit jobless rates, illustrates this point. The higher economic efficiency is, the lower unemployment can be without triggering wage and price inflation. Nor should it be surprising that the Midwest leads the nation in cost rationalization. The one-time Rust Belt, battered by low-cost imports and burdened by high joblessness, had to improve its economic efficiency sharply in order to survive. Once started, institutional shareholders have insisted that the revenue gains continue, making rationalization a continuing process. This process of cost rationalization has spread throughout the whole country, substantially altering the U.S. economy. It has reduced the trigger jobless rate, allowing the Midwest to sustain unemployment well below 5%. Economists understand that the trigger rate of joblessness does change over time. In the 1960s, for example, it was generally thought to be in the neighborhood of 4%. The consequences, however, do not stop with lower unemployment. Most notably, efforts to improve cost efficiency have helped push up corporate profits as a share of national income, reversing a two-decade decline. The effect has been dramatic. The four-year growth in inflation-adjusted earnings per share in the S&P 500 has reached a record high. That explains the robust stock market and suggests that equity prices will continue to rise as long as cost rationalization persists. If Washington doesn't mismanage the process--by, for example, adopting any of the anti-downsizing nostrums being bruited around--today's rationalization will provide the foundation for the best sustained performance of the U.S. economy since the 1960s. Like the '60s, this new golden age will be characterized by strong profits, low inflation, modest unemployment, rising financial-asset prices, rapid investment, robust productivity gains and a resumption in the growth of real wages and living standards. Books will be written, and read widely in Europe and Japan, on how to manage like the Americans. Mr. Gebhart is chief economist at First Chicago NBD Bank.
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