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ALM
First Financial Advisors
Economic Overview
First Quarter 1999
TOPICS
COVERED
Introduction
In last quarter's economic overview, I wrote about two groups
of economists - those looking for inflation and those looking
for an economic downturn. Since then much has been written
about the theoretical underpinnings of the growth-leads-to-inflation
viewpoint of many economists. This viewpoint is based upon
the work of A.W. Phillips in 1958, and his Phillips curve
theory.
The overview this quarter will discuss the history and application
of the Phillips Curve. We will then discuss its validity in
today's economy by taking a look at the so-called new economy
viewpoint.
I'm reminded
of the old joke about economists. "Why are there no one-armed
economists? Because then they could not say, but then on the
other hand…" But before we get into all of that
good stuff, lets take a look at the past quarter.
Last Quarter
The Federal Reserve stayed the course during the last quarter
with no changes in the targeted Fed Funds rate. This was just
as we, and to be honest almost every other Fed watcher, expected.
With no clear sign of inflation or recession the Fed had no
incentive to make any changes. In fact there was not even
a signal of a future change in their bias.
Our forecast of the two-year Treasury rate did not fare quite
as well. Our anticipation that the two-year rate would remain
in a 4.40 - 4.75% band was torpedoed by a series of strong
economic numbers released in late January and early February.
It began when the fourth quarter GDP was revised upwards to
a 6.0% growth rate, about 50 basis points above expectations.
Then both the National Association of Purchasing Managers
(NAPM) and the Chicago Purchasing Manager survey recorded
large increases, suggesting growth in the dallying manufacturing
sector. These indicators combined with a continued very tight
labor market put the fear of inflation back into the bond
market. This fear drove the yield on the two-year Treasury
up to 5.20% before things calmed down and rates started to
retreat. The two-year ended the quarter with a yield of 4.98%.
What
is the Phillips Curve?
Strictly speaking the Phillips Curve illustrates the relationship
between the rate of change in prices and the rate of unemployment.
The British Economist A.W. Phillips noticed that there had
been an inverse relationship between the rate of change in
wages and the unemployment rate in the United Kingdom. From
his work, many of the leading economists in the 1960's believed
that expansionary economic policies would stimulate output
and reduce the rate of unemployment, but that the tradeoff
would be higher inflation.
The primary
output of this theory today is the belief that a level of
unemployment exists below which wage and price increases accelerate.
This level is often called NAIRU (pronounced nay-roo). It
stands for "Non-Accelerating Inflation Rate of Unemployment".
This is a horrible sounding and somewhat misleading name.
It really means "the rate of unemployment which leaves
inflation constant". It was sometimes called the "natural
rate" of unemployment. That is an even worse term because
it is hard to believe that there is anything "natural"
about this.
 The
Phillips Curve and its by-product, NAIRU, definitely have
some intuitive appeal. As the unemployment rate drops companies
will have to pay more to hire and retain employees. This increased
cost of doing business will force firms to raise prices on
their products, thereby triggering inflation. Admittedly this
is a very simplified version, but it provides the gist of
the theory.
Given
current unemployment levels it is easy to see why adherents
to the Phillips Curve concept are worried about increasing
inflation and therefore arguing for a Fed tightening.
The
so-called 'New Economy'
The new economy adherents say that in the old economy booms
led to inflation, causing the Fed to tighten, which eventually
triggered a bust. In the new economy, global competition keeps
a lid on inflation. Competitive companies cut their productivity,
and innovate. By offering consumers better goods and services
at reasonable prices, they sell more units.
The two
keys of the new economists are global competition and increased
productivity. New economists believe that the link between
wage increases and inflation is broken. Quoting the Bear Stearns
publication The Global Spectator, a definite new economy
periodical, "Wage increases are not inflationary but
should be viewed as the reward to more productive labor in
a competitive market economy. There is no other explanation
that fits the facts for the period 1995-97 since wage increases
were rising, inflation was falling and, at the same time,
profits as a share of GDP were rising."
Just-in-time
inventory, outsourcing, and increased computer power are areas
pointed to as providing successful productivity increases.
Discount department stores are often discussed as an example
of productivity. Through the use of powerful computer networks
and just-in-time inventory, discounters have been able to
cut costs and prices. As a result their sales have approximately
doubled over the last seven years to 190 billion dollars.
This actually contributes to disinflation. Meanwhile all other
department store sales have increase by only about 10% over
the same period.
Global
competition is the other major tenet of the new economists.
The idea is that the increased global competition has severely
limited the ability of corporations to raise prices. Wage
inflation, therefore, is much more likely to reduce corporate
profits than lead to a full-scale increase in inflation.
Which
group is right?
The simple answer is we do not know. It is a lot easier to
use economics to explain the past than to predict what will
happen in the future. However, we tend to think that there
have been some structural changes in the economy that make
us lean towards the new economy viewpoint.
 Average
hourly earnings growth has been on a clear downward trend
since the second quarter of last year. This slowdown in wages
is confirmed by the employment cost index, which posted the
slowest increase in wage rates in two years. These wage trends
are contradictory to the predictions of the Phillips Curve-NAIRU
model since wage increases are slowing while unemployment
is falling.
There
has also been some increase in productivity as evidenced by
a dramatic uptrend in the real business sales per worker over
the last couple of years. Therefore, It is our view that the
current low level of unemployment is not by itself inflationary.
Other
Factors
 The
major inflationary threat comes from OPEC. Their newfound
cohesion and recent promise of production cuts has pushed
oil prices up $5 per barrel since the recent lows. This increase
is believed to have some impact on future consumer inflation.
The 1999 increase in CPI will most likely be greater than
the 1.5% increase in 1998, with a consensus estimate of approximately
2.0% -- still low by historical standards.
The major threat of an economic slowdown is that the consumer
will stop spending so freely.
 The
meteoric rise in the stock market has slowed somewhat this
year. This may reduce some of the wealth effect spending that
has occurred over the past couple of years. Also, last year
real disposable income rose by 3.0% while real consumer spending
rose by 5.0%. This seems to be an unsustainable margin. Consumer
confidence remains high, however.
The
Forecast
Economic growth for the first quarter of 1999 should come
in around 4.0%, but we expect growth to begin slowing for
the rest of the year.
We continue
to believe that the FOMC is in no position to raise or lower
rates. The current Fed Funds rate of 4.75% should hold throughout
the coming quarter.
The two-year
Treasury rate ended the first quarter at 4.98%. We are looking
for a slight downward drift in the two-year rate over the
quarter due to slowing growth. Our projected trading band
for the April - June period is 4.70% - 5.10%.
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