Have we accepted that, relative to the 1970s and 1980s, the economy, including San Diego’s, can have stronger growth and lower unemployment without generating inflation? Maybe. And it might just be true.
    After four years of rapid economic growth, San Diego has put nearly everyone to work. The pool of available workers and the unemployment rate continue to shrink.
    The pool of available workers includes both people who are unemployed and actively looking for work, and those who are not in the labor force but who would like a job — so called discouraged workers. The Bureau of Labor Statistics reports that nationwide the pool of available labor has steadily declined since 1994.
    Locally, payroll employment gains have been steadily shrinking for the past two years and the unemployment rate remains very low — 2.7 percent in November, the lowest in 40 years. This seems to indicate that the economy is, indeed, running out of workers, and seems to square with anecdotal evidence that employers are having difficulty finding qualified workers and turnover rates are rising. Qualified workers are in high demand, in part, because of the employment growth in our emerging technology clusters.

    Engines Of The Modern Economy
    In the San Diego region, 16 industry clusters serve as the engines of the local economy. These clusters are groups of interrelated industries that drive income and wealth creation in our region, primarily through the export of goods and services. Cluster industries are supported by, and rely on, various linkage industries. These linkages are an efficient network of buyer-supplier relationships and solid regional infrastructure. Linkage industries include business and distribution services as well as product components, such as printed circuit boards.
    Cluster industries that compete nationally and internationally drive our economy and have far greater long-term growth potential than non-cluster industries. Because clusters compete at a global level, their markets are not constrained by the size of the local economy. In addition, export-oriented businesses bring outside dollars into our region; these dollars drive the regional economy as firms buy products and services from other sectors in the region. Our ability to create a prosperous economy is dependent on the health of these industries.
    Today, our economy is being driven by new cluster industries like biotechnology, software, environmental technology and communications that do not fit the classic employment definition like services, retail, trade and manufacturing.

Source: Labor Market Information Division, California Employment Development Department

    Unemployment's Steady Decline
    The unemployment rate has been inching its way lower. The rate has fallen in each of the last four months, and declined a full percentage point since January 1999. The trend is typical for our economy in good times, but falling below 3 percent in both October and November makes it the lowest rate in 40 years. When the numbers come in, December's rate should be lower yet, thanks in part to rising retail sales. The rate is expected to pop up in January 2000, typical for the time of year, but remain below 4 percent for most of 2000.

    Inflation: Good News/Bad News
    On the inflation front, the good news is the steep rise in oil prices over the past year seems to have leveled off, and is expected to fall some this year. At the $26 per barrel price today, many marginal producers that cannot produce profitably with oil prices below $20 per barrel are drawn back into the market, increase supply and dilute OPEC's market share. This likely will convince OPEC to lower the pricer. (Don't ya just love the price effects from good old competition? Just what we need locally, right Mr. Roberts?)
    You might think that the tight labor market would be bad news for inflation. I’m not completely convinced that it isn’t. But recent evidence from the Federal Reserve identified some trends in compensation that help explain why the employment compensation index, a measure of wage rate trends, has been flat or decelerating recently.
    More of our workers are being compensated with stock options and bonuses, which are excluded from the index. Furthermore, the use of these variable pay packages may have lowered the infamous non-accelerating inflation rate of unemployment. Moreover, in the long run, flexible compensation also could minimize cycles in employment. For example, if the economy hits a downturn, employers can simply eliminate bonuses and retain their workers at their still-low base pay rates. If the economy is good, as it is now, employers can keep their workers by providing additional bonuses, thus stabilizing the unemployment rate. Given the changing structure of our economy, with more new jobs coming from emerging growth technology companies that are equity and bonus oriented, San Diego may be in the forefront of this expanding trend.
    The bad news is the 1999 data show the core rate of inflation is beginning to level off nationally and rise locally, after a long slide. In the San Diego region inflation is projected to rise by 3.8 percent in 2000. Locally, through the first half of 1999 the consumer price index, a measure of inflation, rose at an annual rate of 3.4 percent, far above the 2 percent recorded during 1998.
    The accelerating rate of inflation reflects the rise in local home prices and rental rates. The shelter portion of the housing component of the CPI, weighted to account for nearly 40 percent of the total index, rose 5.7 percent through the first half of 1999. Without the shelter component, the index would have risen a much less 2.1 percent.

    The Most Feared Competitor — The Internet
    Before finishing with the outlook for inflation, it is important to report the consensus view of the expected impact of the Internet on inflation. The Net is a new type of competition, and so far deflationary. Studies have shown that Internet prices are, on average, 15 percent lower than retail. Also, most Internet purchases are not being subjected to sales tax. If a consumer buys the same item in a store, the local retailer would be forced to levy a sales tax. Locally, for example, the sales tax is 7.75 percent. So, for a San Diego resident, the Internet savings are the sum of the 15 percent discount and the 7.75 percent sales tax for total savings of 22.75 percent relative to what he or she would have had to pay in a store.
    At the moment, e-commerce is small at just 1 percent of retail sales. But it is doubling every year, and is expected to continue that way over at least the next five. Furthermore, every time a new product is offered on the Net, the price of that item is subject to intense competition and may be forced downward. As the Internet expands and more and more goods and services become available, this downward pressure on inflation will intensify.
    While the Internet establishes an upper limit on prices, it also enables firms to lower their costs. Automobile manufactures are beginning to sell directly to the customer via Web sites. Airlines are eliminating reservations clerks and travel agents by booking sales directly over the Internet. (Remember what happened to bank clerks with the arrival of ATMs?)

    Housing: Slow Progress, Higher Prices
    A growing concern locally is that housing construction is not keeping pace with population growth. During the 1970s, the region built, on average, one new housing unit for every 1.9 new residents. In the 1980s, it was one new housing unit for every 2.8 new residents. In the 1990s, however, this ratio has dropped sharply to one unit for every 4.5 new residents, and in 1998 the ratio was one unit for every 5.2 new residents. No wonder household size — the number of persons per housing unit — continues to rise.

Source: Labor Market Information Division, California Employment Development Department

    The discrepancy between population growth and home construction has spawned a housing crunch, leading to higher home prices and very low vacancy rates. Our current level of population growth, between 55,000 and 60,000 people per year, requires the construction of about 17,000 new housing units each year. We added just 11,200 units during 1998, far short of the requirement. However, we may have hit a turning point during 1999; through October we were on a pace to authorize 17,000 new housing unit permits. If the pace held through the end of the year, 1999 will be the highest year for the entire decade of the '90s.
    Despite the number of units that may be authorized during 1999, there remains a shortage of homes for purchase and rent in the region. One side effect of this shortage is rising home prices. Home prices have been rising at double-digit rates for the past two years, and are expected to rise by 15 percent during the coming year. This price rise, combined with an expected increase in interest rates, likely will make our region one of the least affordable housing markets in the nation.
    Having said all this about home prices, did you know that the growth in household income has outpaced home prices during the decade of the 1990s?

    Interest Rates — Tapping The Brakes
    The rise in interest rates this year, pushed through by the Federal Reserve, will affect economic growth with a lag of six to nine months. The three Fed rate hikes between June and November 1999 should slow the U.S. economy by spring 2000. Apparently, this is not enough. The Fed may be planning additional interest rate hikes because the nation's economy seems to have picked up steam during the second half of 1999, exceeding the speed limit posted by the Fed. Pressure on wages, although tough to measure, may be increasing and Asia and Europe seem to be growing again.
    I expect the Fed to begin talking tough early this year, and follow it up with a 25 basis point rate hike at the February or March Federal Open Market Committee meeting. Never satisfied with one tap on the brakes, the Fed likely will raise rates another 25 basis points some time in the second quarter. So, by June, the federal funds rate should stand at 6 percent and mortgage rates 7.72 percent.
    So, back to the original theme of this article. We are starting a new millennium and economies like San Diego’s are in the forefront, evolving into an economic paradigm — not an end to the business cycle, but some new radical shifts that have effected the economic principle on which the cycle is based. You may need some new navigation tools and information to chart a safe course.

Marney Cox is the chief economist and director of regional economic planning and research for the San Diego Association of Governments.