From the October 2006 issue of Wealth Manager Web • Subscribe!

Working It

Economists love a good tradeoff, and their all-time classic is between inflation and employment: As employers need more and more workers, they have to raise wages to attract them. As more money goes into the economy, prices go up, too. Likewise, as people lose jobs, they have less money to spend, and prices have to go down. Employment is considered relative to an optimum point, called the "Non-Accelerating Inflation Rate of Unemployment" or NAIRU in academic circles; to everyone else, it's either the "natural rate of unemployment" or just a big relief.

At NAIRU, there is just enough unemployment to reflect new graduates looking for first jobs, folks returning to work after a few years of family leave, career changers, and people fired for incompetence. Most workers who need jobs can get them, most employers who have job openings can fill them, and price increases reflect economic growth--not too much money chasing too few goods. This magic number varies a little depending on who's talking, but most economists think that it is about 4 percent.

The overall unemployment rate in June 2006 was 4.6 percent, below the unemployment rate of 5.0 percent in June of 2005. That would correspond with higher inflation, and that's what the numbers illustrate. The Consumer Price Index, the usual measure of inflation in the United States, showed that prices in June 2006 increased 4.3 percent from the June 2005 level when the inflation rate was running at 2.5 percent.

"Wages are the link between employment and prices," says Tom Hyclak, professor of economics at Lehigh University. If businesses are short workers, they'll raise pay to attract qualified applicants. Or, they can keep wages low by using technology to get the same work done with fewer hands on deck. Whether it's air conditioning, word processing, or just-in-time inventory, any system that helps workers produce more will help employers manage their demand for workers and will keep wages below the point of increasing inflation.

If the business cycle is really strong, some businesses will pay more than the workers are worth. Or, they can take advantage of globalization to find lower-cost workers. Outsourcing engineering work to college graduates in India and manufacturing work to high-school graduates in China can relieve pressure on wages and prices here, allowing the economy to chug along without the wage pressures that raise prices. But even that has its limits: India's inflation rate was 4.98 percent at the end of June, and there is anecdotal evidence that wages of workers in outsourced businesses are rising faster: At some point, outsourcing is no longer effective as a means to manage U.S. inflation.

In a global economy, "The primacy of labor market conditions is somewhat reduced," says Richard DeKaser, chief economist at National City Corporation in Cleveland. "But it's still the single most important factor." And yes, it trumps what happens at the gas pump.

Inflation is tied to unemployment because it shows how much money is in the economy relative to the numbers of goods there are to buy. (This is the monetary approach.) If people spend less cash on one item, they'll spend more on something else. With gas prices going up faster than inflation, people may choose to keep their old cars or eat out less often. Other prices change much less than inflation, and the total price level in the economy stays the same.

But that doesn't mean that price levels won't play out in the job market. "Expectations theory" says that inflation is more about what people expect will happen to prices rather than what is happening now. For example, if they see an increase in gas prices as a short-term phenomenon, they'll suck up the prices at the pump for now. But if they expect that they will be a long-term fixture, they'll start asking for bigger raises to help them meet their costs of living. And as wages go up, so will inflation.

And it's not just wages that carry inflationary expectations, by the way. "Lehigh University makes a decision about the price of its tuition in February," Hyclak says. Those increases are based on Lehigh's expectations about what its costs will be for the coming year and have to be paid even if Lehigh's administration has guessed too high.

In other words, if you care about what will happen to stocks and bonds in an inflationary environment, the number to watch is still unemployment. "If you think you can predict the price of oil, then going long commodities is a good idea," says Richard DeKaser. "But the inflationary fears now are not about the price of oil, but what's going on with the unemployment rate."

Ann C. Logue, CFA, has worked as an analyst and written for Barron's among other publications.

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