January 1998 • Volume 8 • Number 1
The 1998 Outlook:
Slower Growth and Stable Inflation
By Michael K. Evans, Ph. D.
1997 was a very good year. The growth rate rose to 3.7 percent, and the unemployment rate fell below 5 percent — all accompanied by a decline in the inflation rate. But while the U.S. economy appears to be functioning smoothly, that certainly cannot be said for the rest of the world. Indeed, the stronger dollar, plus the collapse of the former growth tigers in Asia and the Brazilian austerity program, are likely to reduce U.S. export growth from 10 to 11 percent in 1997 to 4 to 5 percent in 1998, knocking a full percentage point off the overall growth rate.
Having said this, we hasten to point out that 2.7 percent is not necessarily a suboptimal growth rate; the slowdown in the economy will reduce the chances of wage and price acceleration, higher interest rates and an eventual recession. Yet considering that exports have been one of the keys to non-inflationary growth over the past few years, it would be inadvisable to overlook this recent negative development.
The Supply Side: No Rise Ahead in Core Inflation
Since the main concern of many forecasters is that the U.S. economy will overheat, causing higher interest rates and a recession, we address that issue first by looking at the performance of the economy on the supply side.
Short of another war or energy shock, commodity prices will not accelerate in 1998; if anything, they will fall. The world is awash in excess capacity; growth will be sluggish in Europe and anemic in Asia, as the once high-flying tigers have been grounded. At the finished goods level, quality-adjusted motor vehicle prices will decline for the second year in a row, and a weighted average of machinery prices, including computers, will also continue to fall.
The key issue on the supply side is the condition of the U.S. labor market. Three years ago, many economists claimed that inflation would accelerate as soon as the unemployment rate fell below 6 percent; that estimate was lowered to 5.5 percent; then 5 percent, and now it is at 4.5 percent. The contrary argument is, of course, that the tradeoff between unemployment and inflation need not occur at all; the reason inflation used to rise at full employment was a combination of inappropriate fiscal, monetary and trade policies — none of which are currently in existence.
Much of the discussion of why growth will moderate in 1998 focuses on labor market conditions. The fact that many qualified jobs go unfilled is not questioned. But the real issue is whether these job shortages will drive up wage rates, causing higher inflation and interest rates to cut deeply into growth — or whether the lack of qualified applicants will simply result in slower growth in production but no rise in labor costs or inflation.
To examine the issue, we look at the recent changes in wages, hours, employment and unemployment for major industries. The results are actually the opposite of what would happen if labor shortages were driving wage rates higher. According to this hypothesis, the biggest wage gains would occur in those industries with the lowest unemployment or the biggest gains in employment. In the durable goods manufacturing sector, though, where the unemployment rate is only 3.3 percent, wages have risen a minuscule 2.2 percent over the past year.
Thus, instead of the Phillips curve tradeoff, the evidence shows that the biggest wage gains occurred in those industries most affected by the increase in the minimum wage — which also show the greatest weakness in hiring. The apparel industry, where wages have risen 4.6 percent over the past year, has suffered a 6.0 percent drop in employment as jobs have moved to cheaper locations overseas. Retail jobs can't move overseas, but the rise in the minimum wage there has pushed the unemployment rate up to 6.3 percent, with a substantial drop in the length of the workweek.
Hence the biggest percentage wage gains are occurring at the bottom of the scale because of the boost in the minimum wage and are reducing employment opportunities in those sectors. On the other hand, in the industries with most severe labor problems as measured by low unemployment rates, wage gains are less than average.
Admittedly there is some dichotomy between the manufacturing sector, where jobs can more easily be transported overseas, and the rest of the economy. Nonetheless, except where the minimum wage hike has been important, wage gains have also remained below 4 percent in the service sector. The only sectors in which wage gains are likely to accelerate in 1998 will be those accompanied by corresponding gains in productivity, which means unit labor costs will not rise.
The International Outlook
For the rest of the world, though, the analysis is quite different. With double-digit unemployment rates in Europe and massive overcapacity in most Asian countries, the issue is whether these regions of the world can crank up demand enough to boost growth rates and induce at least some modest decline in the unemployment rate.
For continental Western Europe, that finally seems to be the case. The key factor, perhaps not too surprisingly, has been the stronger dollar, which has spurred exports both to the United States and in markets where European producers compete with the United States. As usual, the key performer is the German economy. Indeed, this is the first time in almost a decade that the German economy is benefiting both from low interest rates and a currency that, while still overvalued, still allows its firms to compete in worldwide markets.
This would not be possible if stronger growth were to rekindle inflationary pressures in Europe, but the European inflation rate should not budge in 1998, keeping interest rates near current levels.
The third ingredient necessary for above-average growth in Europe in 1998 is a pickup in capital spending. Over the past few years, many German firms have chosen to move operations out of the country, especially to Eastern Europe. Recently, though, there has been a slight but noticeable move back into Germany — by U.S. and Japanese as well as German firms. While these new plants are concentrated in highly capital-intensive industries, they will also provide some modest gains in employment.
Real growth in 1997 for the original six Common Market countries will average 2.3 percent, with growth for all of Western Europe, excluding the United Kingdom, at 2.8 percent. For 1998, growth in the original Common Market countries should rise to 3 percent, with growth for continental Western Europe rising to 3.5 percent.
Growth in the United Kingdom, by comparison, will weaken for the same reason that the continental European countries are strengthening: The pound has appreciated this year, the only currency to rise relative to the dollar. Also, inflation has crept back above the 3 percent mark. Hence growth in the United Kingdom will fall from an estimated 3.3 percent in 1997 to 2.5 percent in 1998.
The outlook is much dimmer for Asia. The Japanese economy will remain stagnant in 1998, growth in the emerging nations has crashed, and the growth rate in China will probably be cut in half for the coming year.
Interest rates are near rock-bottom levels in Japan. Short-term rates have declined to .5 percent, and the 10-year benchmark government bond yield has fallen to 1.75 percent. The yen has fallen about 35 percent relative to the dollar from its 1985 peak, but Japanese production costs still remain well above those in other Asian countries.
In spite of lip service to the contrary, Japan continues to isolate itself from world trade patterns. Exports are welcome, but imports are not. The manufacturing sector continues to be gutted as firms move operations to offshore locations, and Japanese businessmen remain extremely pessimistic about the course of future business activity in their country.
The collapse of the Thai baht, the Malaysian ringgit, the Indonesian rupiah, the Philippine peso, and the South Korean won apparently caught foreign exchange traders by surprise, but all the warning signs were there. Unlike Japan (and to a lesser extent China), which have substantial trade and current account surpluses, all of these countries have substantial current account deficits. To compound the problem, local firms borrowed heavily in foreign markets because interest rates were lower abroad.
Speculators bent on destroying the Brazilian real may find that the austerity program announced in response to the downward pressure on the currency will keep the currency from declining relative to the dollar. We think the government is likely to be successful in defending its currency. On the other hand, such a program would reduce real growth in Brazil to zero in 1998 — which would clearly hurt U.S. exports to that country.
One could perhaps argue that the 30 to 40 percent depreciation in the currencies of Thailand, Indonesia, Malaysia and the Philippines will help to correct their trade imbalances. Yet the problems run deeper than that; firms that overleveraged on foreign debt will essentially have to be bailed out by the government, which will balloon the money supply and create further inflationary pressures in these countries. In addition, the lack of infrastructure investment in these countries, and the puny amount invested in education, will lead to political unrest that at least in the short run can only be solved by having the government throw even more money at the problem. Thus we do not see these countries rebounding for several years.
The Demand Side — Slower Growth Ahead
We can summarize the U.S. outlook for the coming year by noting that, in 1997, the twin engines of growth were exports and capital spending, both of which rose at double-digit rates. Realistically, that performance cannot be repeated.
There is no doubt that exports will grow more slowly in 1998 — but that is not the only fallout from the collapse of the Asian economy. With massive worldwide excess capacity, U.S. firms will cut back on their domestic capital spending plans, especially in those high-tech areas where declining price pressures are most likely to occur. Hence the superheated growth in capital spending will also come to a halt.
Consumer spending cannot be expected to pick up the slack. It followed the rapid gains in employment and real wages in 1997, but did not independently boost the growth rate. Consumers do not have much room left to maneuver. After averaging 5.6 percent for the 1990-93 period, the personal saving rate fell to 4.3 percent in 1996, with a further decline below 4 percent in 1997 — the lowest level since 1951. It is clear that consumers are spending all the income they can get their hands on, and are not overly worried about rainy days in the future. Thus, if there are any cutbacks in employment or real wages, consumer spending would decline proportionately.
The not-so-good news for 1998 is that lower growth rates in exports and capital spending will reduce the overall growth rate below 3 percent. The better news is that slower growth will further reduce the chances of higher inflation and lead to lower interest rates, setting the stage for a continuation of the current expansion.
Michael K. Evans, Ph.D., serves as a consulting economist for APICS and prepares the APICS Business Outlook Index, which appears monthly in APICS—The Performance Advantage.
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