Clear signs that inflation is picking up in the United States after nine years of economic expansion sent a shockwave through the financial markets yesterday. The Federal Reserve Board is now likely to increase interest rates by half a point next month, in the sixth rise in 11 months, Wall Street analysts said.
Two sets of figures set off the alarm. In a sign that the tight jobs market is finally boosting pay growth, the Labor Department's employment cost index jumped 1.4 per cent in the first quarter of this year, its biggest quarterly rise since late 1989.
Separate figures showed that GDP growth slowed to 5.4 per cent in the first quarter, down from 7.3 per cent. But domestic demand growth accelerated to a staggering 8 per cent from 5.9 per cent at the end of 1999.
Worse, the consumer price deflator jumped 3.2 per cent, its biggest gain in more than six years. The overall growth slowdown was entirely due to the huge trade deficit, and the mix of inflation and growth during the first quarter was far less benign than it has been so far during the record-breaking expansion.
The figures sent the Dow Jones index diving by as much as 198 points, to 10,747.56, although it recovered to stand 140 points, or just over1 per cent, lower later in the morning.
The disappointing inflation figures left economists warning that hopes of a soft landing for the American economy and stock market were receding.
Alan Greenspan, chairman of the US Federal Reserve, is "caught between the risk of creating turmoil in the stock market and the risk of inflation," said Brian Fabbri of Paribas in New York. "His job is keeping inflation low, so now the Fed has to get tough."
James O'Sullivan at JP Morgan said: "One way or another we need the economy to slow down. What is still unclear is the mix we are going to get between higher interest rates and weaker stock prices."
Many Wall Street analysts now believe that the meeting on 16 May of the Fed's policy committee will bring a half-point rise in interest rates from their present level of 6 per cent, with perhaps another half point required later.
Yesterday's figures made it clear that American consumers are still on a spending binge. Consumer spending grew at an annualised rate of 8.3 per cent, up from 5.9 per cent in the fourth quarter of last year. The personal saving rate dropped to just 0.3 per cent, its lowest since 1933.
Investment spending was also buoyant, growing 21.2 per cent in the quarter after dipping to 2.9 per cent ahead of the turn of the millennium. But exports fell 0.2 per cent, while imports surged by 9.5 per cent.
The impact of the tight jobs market was clear in the employment cost index, up by 4.3 per cent compared to a year earlier. Wages and salaries grew by 4 per cent and benefits and bonuses rose 5 per cent.
The evidence of growing pay pressures came after disappointing consumer price figures two weeks ago. To control inflationary pressures, the Fed will need to slow US growth by about half, economists say.