The tensions created by trying to cover rising costs with higher prices have put businesses and the Fed on a collision course that suggests higher interest rates and lower profits lie ahead.

Key indicators are signaling a slight pick-up in the U.S. economy, growth of which will still approach 3 percent, according to an analysis released today by The Conference Board. However, analysts fear higher interest rates on the horizon will hurt corporate profits.

"Although the current economic cycle is now entering its sixth year of expansion, there are few signs of what economists might refer to as 'cyclical aging,'" says Gail D. Fosler, Executive Vice President and Chief Economist of The Conference Board. "Growth has moderated, but inflation appears under reasonable control."

Corporate profits, which have risen faster in this business cycle than in any other post-war cycle, are one of the most reliable indicators of cyclical health. More specifically, they provide valuable clues about the future of the U.S. economy and the corporate sector. Corporate profitability is also a key long-lead indicator of possible recession risks. Fosler expects corporate profitability to peak this year, and that overall profit gains should remain solid for the foreseeable future.

"But the forces driving corporate profitability will likely become more adverse as we get further into 2007," says Fosler. "Slowing productivity and rising costs do not bode well for the future."

Many of the companies that have enjoyed lower costs during the early years of this decade have recently had to offset higher costs through higher prices, a tactic that is in direct conflict with the Federal Reserve Board's inflation mandate. Additionally, the moderation in growth is likely to set off a period for jockeying for profitability within the value chain.

Productivity is an important tool for keeping costs down because when it slows, costs tend to rise. Unit labor cost restraint was an important source of profitability for manufacturing and the total economy from 2001 to 2004. But it is not the only player. As compensation costs rise and productivity gains wane, job growth picks up. This can put upward pressure on compensation when the unemployment rate is low.

Total compensation, as measured by the National Income accounts, is rising at a 6 percent annual rate. Although productivity and compensation tracked each other closely in the early years of this decade, compensation has recently started outpacing productivity. Companies have been able to offset the greater cost with higher prices, and margins appear to have stabilized or even peaked for this cycle. The tensions created by trying to cover rising costs with higher prices have put businesses and the Fed on a collision course that suggests higher interest rates and lower profits lie ahead.