Payroll employment rose for the sixth consecutive month in February, but the increase was barely above zero. Moreover, all of the gain was in government employment, and payroll jobs in December and January were revised down. While the unemployment rate did not increase, it remained unchanged only because civilian labor force and household employment both declined.

Was there not a ray of hope anywhere? Yes, if you searched for it with a fine-toothed comb and a magnifying glass. Employment of temporary workers increased by 32,000, and jobs in durable goods manufacturing actually rose a little. But it was an extraordinarily weak employment report for an economy in its 27th month of recovery from recession.

Does the February employment report mean that the economy's growth is slowing? There are a few signs of weakness around the edges. The ISM indexes for both manufacturing and non-manufacturing declined a bit last month-but both remained at lofty levels. Consumer confidence fell in February, and auto sales early this year remain below fourth-quarter levels. Consumer spending in other areas, however, remains robust. More generally, there a number of signs of continued solid growth. Business capital spending is on the rise; businesses are adding to their inventories; and exports are increasing. There is insufficient evidence of slower growth to explain the lack of stronger labor demand in February.

The alternative explanation is that productivity continues to advance at a remarkable pace, limiting the need for additional workers to permit increases in business output. Over the past three years, productivity has increased at an annual rate of 4.2 percent, and the first-quarter rise is likely to be close to that figure. This is well above most estimates of the longer-term trend, which are in the range of 2-1/4 to 2-3/4 percent per year.

Strong productivity growth is widely considered as a sign of economic health, and rightly so. It could translate into increases in real per-capita incomes. Moreover, the Federal Reserve has stated in recent releases that robust growth in productivity "is providing important ongoing support to economic activity." In the context of rising real GDP, increases in productivity add to business profits and to employee compensation, but the proportions vary over time. For example, during the acceleration of productivity in the last half of the 1990s, the share of corporate profits in national income rose from 10.4 percent in Q4 1994 to 12.2 percent in Q3 1997. During this period, the share of employee compensation fell from 64.7 percent to 63.7 percent. From Q3 1997 to Q3 2001, employee compensation's share rose to 66.8 percent while corporate profit's share fell to 8.0 percent. Since then, the gains in productivity have gone heavily to business profits: corporate profit's share has risen to 11.5 percent while employee compensation's share has fallen to 63.5 percent. As a consequence, aggregate real wages and salaries (wages and salaries deflated by the chain-price index for personal consumption expenditures) are currently at about the same level as they were three years earlier.

Rising corporate profits or increased real incomes of workers both contribute to strengthening aggregate demand. Higher corporate profits encourage businesses to invest. They also push up stock prices, which adds to consumer wealth and stimulates consumer spending. Increased real incomes of workers, of course, are a major source of support for consumer buying. Additional support for these expenditures during the past several years has come from sizable tax cuts in 2001 and 2003, together with record levels of mortgage refinancings in which individuals have lowered monthly payments and cashed out a substantial amount of equity. These sources of support for retail buying are now waning. If aggregate real wages and salaries continued to languish, it would be difficult to maintain a robust pace of growth in personal consumption expenditures--which constitute two-thirds of GDP--through the remainder of the year.

Exceptionally strong growth of productivity thus poses a dilemma. It would be highly beneficial for the economy in the long run, but it might undermine the principal source of real income which consumers depend on to finance their day-to-day expenses.

Our forecast resolves the dilemma, as was the case in previous forecasts, by assuming that the growth of productivity slows to a more normal pace this year-about 2?1/2 to 3 percent at an annual rate. Payroll job creation then picks up to between 150,000 and 175,000 per month, sufficient to sustain a satisfactory pace of workers' real incomes and consumer spending. Together with rising business capital spending, increased inventory investment, rising exports, and continued growth of federal government purchases, the economy is expected to grow over the four quarters of this year by 4?1/4 percent. The assumption about productivity growth seems quite reasonable, since it cannot continue indefinitely at a pace well above the long-term average. But no one knows for sure how long rapid advances might persist. And if they were to continue throughout this year, the 4?percent?plus rate of economic growth that we and others are forecasting for 2004 would be in jeopardy.

An alternative way in which the productivity dilemma could be resolved would be a significant further decline in the rate of inflation, which would increase real wages and distribute more of the gains from rising productivity to workers instead of business profits. That is what occurred in the latter half of the 1990s. But under current circumstances, a further decline in the rate of inflation would push it down close to zero, or perhaps even below zero, a situation that would undoubtedly make the Federal Reserve rather uncomfortable.

The February employment report thus sends a very clear message about Federal Reserve policy: the Fed is not about to start raising interest rates at any time soon (which is why the yield on the 10-year Treasury has dropped sharply since March 5). To do so would risk slowing the economy at a time when it might be slowing on its own; alternatively, it might risk pushing the inflation rate into negative territory. Our forecast has for some time anticipated that the Fed would wait until late this year (the December Federal Open Market Committee meeting) before starting to raise short-term interest rates to more normal levels. We continue with that assumption in this forecast. If we are wrong in that respect, the Fed's first move to raise interest rates will be later rather than sooner.

Source MBAA

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