Published in the Financial Times on May 31, 2004

Stephen Cecchetti Professor at the Brandeis International Business School

American companies are hiring again and employment is rising at last. Even so, after the robust (and largely unexpected) job growth of the first half of the year, there are still fewer people working than there were four years ago. And the paths of productivity, corporate profits and inflation have all diverged from what most people had come to expect. Constructing a story that ties together the slow recovery of employment with high productivity growth, strong corporate profits and the anomalous behaviour of inflation yields two important lessons. First, the productivity burst is likely to be temporary, with growth returning to recent trends soon. Second, the relationship between inflation and employment growth is too unpredictable to be useful.

To understand these conclusions, look back to March 2001, when the US economy began slowing. Three years after a business-cycle peak, employment is normally up a few per cent, productivity has grown by between 5 and 10 per cent and corporate profits have increased by 25 per cent. This time, employment is down but productivity is up nearly 15 per cent and profits have gone up by close to 70 per cent.

The behaviour of inflation has been unusual too. When there is economic slack, inflation generally falls. But despite apparently high unemployment, US inflation is on its way up.

What ties these facts together is the behaviour of corporate managers, whose decisions are often obscured by the statistics economists watch so intently.

The accounting scandals of the past few years posed a challenge. The smoke and mirrors were gone, yet investors still wanted to see earnings growth. The need to make real profits and not just be profitable on paper forced companies to cut costs. This explains the fact that during the 2001 recession, productivity growth exceeded the extraordinary trend rate of the previous four years. But cost-cutting cannot go on forever, so we can be fairly sure that this performance will not continue, but will return instead to the recent 2½ per cent trend.

The need to improve measured profitability cannot fully explain why employment failed to recover. Why were managers refusing even to rehire the temporary workers they had let go? The answer is that there was virtually no appetite for business growth.

To see why, turn to the behaviour of inflation. Until recently, inflation in the US was low and falling. But when average prices are steady, it means some prices are rising while others are falling. And over the past few years it was largely the prices of housing and medical care that were going up, while other prices were either flat or falling.

The mid-1960s was the last sustained period when American inflation was below 2 per cent. Forty years ago even the oldest of today's chief executives was in college. None has any experience with stable average prices. Theirs is a world with inflation.

Managers are willing to enlarge their businesses when they can foresee growth in earnings. When prices are stable or falling, it is difficult to predict revenue increases, so companies refuse to invest and refuse to hire. While employment stops growing, the need to show increases in profits does not, so managers press their existing workers to become more productive.

All of this may sound strange coming from an economist. Economic theory, after all, tells us that rational people do not get confused by inflation. But theory does not always match facts.

The story explains why economic models are doing such a poor job of forecasting inflation. After the experience of the late 1990s, this is not big news. Remember, this was when people thought the productive capacity of the economy was being strained to the point where it would lead to more inflation. Instead, inflation fell.

This time, labour market slack is not driving inflation down. Instead, hiring has restarted only after inflation has picked up. Since they can raise prices again, managers are forecasting growing revenues so they are willing to bring on new workers. Over the next few months, we should see a steady increase in both employment and inflation.

The relationship between economic slack and inflation is subtle. For price stability to be the basis for sustained economic growth, corporate managers will have to become comfortable with a world in which prices are just as likely to go down as they are to go up. If educating them turns out to be too difficult, it may be better to live with at least some inflation.

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