If (profit margins) remain relatively high and unit labor costs continue to advance at or above 2 percent, then we are likely to see inflation continue at about 2 percent.

Should these recent trends in compensation and productivity continue, there is a risk that businesses may be under pressure to raise prices.  Although a risk, there are forces in play that may restrain increased labor cost pressures from contributing to a rise in inflation in 2007.  Some companies, for example, may absorb increased cost pressures through reduced profit margins rather than raise prices and risk losing valued customers.  

Here in Idaho, our contacts tell us that they have noticed shortages of skilled workers, and they also are seeing increasing difficulties recruiting unskilled workers, all of which has put strong upward pressure on wages in the state. While reports like these do heighten my sense of concern, I still draw some comfort from the fact that markups remain very high. So, even with more cost pressures, firms would have the room to absorb the increases without fully passing them on into their prices if competitive conditions in product markets induced them to do so.

Nonetheless, the high level of business profit margins suggests that, even if unit labor costs begin to rise more quickly than prices, the effect on inflation could be muted for a time because firms would have room to absorb some of the cost increases in the form of reduced profit margins...To be sure, margins cannot shrink forever--just as they cannot grow to the sky. But elevated margins provide some cushion against cost pressures being passed through to prices--so long as the central bank does not allow excess demand to develop in product markets.

Although the recent data suggest that the worrisome trend of disinflation presumably has come to an end, still-significant productivity growth and a sizable margin of underutilized resources, to date, have checked any sustained acceleration of the general price level and should continue to do so for a time. Moreover, the initial effect of a slowing of productivity growth is more likely to be an easing of profit margins than an acceleration of prices.

For the period immediately ahead, inflationary pressures still seem well contained. To be sure, oil prices have nearly doubled and some other commodity prices have firmed, but large productivity gains have held unit cost increases to negligible levels. Pricing power is still generally reported to be virtually nonexistent. Moreover, the re-emergence of rising profit margins, after severe problems last fall, indicates cost pressures on prices remain small.