07/ 25/ 2006
by Bill Dunkelberg
As small-business owners struggle to fill vacant job openings, the Fed monitors factors that trigger an inflation hike
The first half of the year is behind us. Although the economy is showing some signs of fatigue (stock market stumbles, ups and downs in initial jobless claims and rising inflation as capacity is strained), it is still growing above the long-run trend rate of growth. This could mean problems with inflation if productivity stops growing fast enough to offset rising labor costs.
How does productivity affect inflation? The math is simple: Unit labor costs are the primary drivers of prices and make up about 80 percent of small firm operating costs. Unit labor cost equals hourly labor cost divided by hourly worker output, or productivity. If hourly worker output—such as customers served per hour, hamburgers served per hour, gears made per hour, etc.—rises faster than hourly labor cost, the unit labor cost falls, and business owners feel no pressure to raise selling prices. But if labor costs rise faster than hourly output, unit labor costs rise, profits fall and firms raise prices. This is the concern of the Fed as it contemplates its moves for the balance of the year.
According to small-business owners, labor markets have been tightening. One in four owners plans to increase total employment. Fifty percent are hiring or trying to hire, but more than 80 percent report few or no qualified applicants for job openings. So one in four business owners are raising worker compensation in an effort to attract new applicants to fill their job openings.
This situation usually signals a peaking of the expansion—not a recession, just a slowdown—as we run out of labor to sustain more growth. We currently employ a near record 63 percent of the work-eligible population (age 16 and over), and the unemployment rate is well under 5 percent. That's a tight labor market, and it's hard for small businesses to grow if they can't hire more employees. As firms try to pay more to attract employees, unit labor costs rise, putting pressure on prices. Inflation rises as a result, triggering the Fed to take steps to slow the economy as it has been doing all year.
The concern about "overshoot" simply arises from the fact that it is hard to forecast the future, so just how high the Fed needs to raise rates to keep the inflation genie in the bottle is not clear. If the Fed tightens too much, the economy could slow down more than we need to control inflation. Monetary policy is art as well as science. So far, small-business owners see a pretty good economy unfolding for the balance of the year, but they have been raising their selling prices at a faster pace than at any time since the early 1980s when inflation was the No. 1 problem faced by the economy. Hopefully, that will abate as we head to the end of the year.
