The Double Whammy That Could Ignite Inflation - Assignment Example

In the year 2005, U.S. productivity grew from 2.9% from 2004. This rate easily surpassed the average 2-1/4% even though its fourth-quarter, in fact, recorded a fall of 0.5% as compared to the third quarter. In the same year, unit labor costs grew 2.6% from 2004. Businesses more than covered the added compensation costs with higher prices. On average, the labor cost of manufacturing a given item jumped 2.6%, but the price of the same item increased faster (at 2.8%). The overall indication of 2005 is that U.S. productivity grew strongly, tight labor markets and upward pressure on wages did not cause problems, and profit margins held up well.

Acceleration in unit labor costs sets off the inflation alarm. The last time this happened was in the late 1990s when the growth of unit labor costs exploded upwards from 0.7% in 1996 to 4.2% in 2000. The inflation threat was however diffused when four factors prevented U.S. companies from increasing prices to offset additional production costs, forcing them to make do with severely reduced profit margins instead: a huge excess in global production capacity in the wake of the 1997 Asian crisis; the financial upheaval caused by the Russian debt default in 1998; global labor markets were not tight due to soft world growth; and, the U.S. dollar had strengthened considerably against other world currencies.

In 2006 however, the global economic scenario is different. The Japanese economy is showing signs of revival after a long slump; Chinese demand is soaking up capacity throughout Asia; global labor markets are tighter in response to accelerating world growth; and the U.S. dollar has weakened considerably, falling to levels even below those recorded in the late 1990s. Due to these factors, commodity prices are strong, emboldening many U.S. companies to successfully increase prices and maintain the high level of profits to counter an increase in costs (particularly energy costs).