Productivity gains return to the US economy

Productivity gains return to the US economy

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The writer is the founder and president of MacroPolicy Perspectives

Rising higher has become the mantra in bond markets this year. It mostly reflects central bankers’ strategy for tackling high inflation — raising short-term interest rates high enough and keeping them at that level long enough to cool economic activity and return inflation to the target level.

Factors other than monetary policy are often cited to explain why inflation and interest rates remain higher this cycle. They include rising government budget deficits around the world and fragmentation of global supply chains as rising geopolitical tensions alter trade relations, leading to a higher core operating rate of inflation.

These factors are only the dark side of the story: The rise in longer-term bond yields that began last summer came primarily after the US economy proved more resilient than expected while inflation fell faster than expected. This was in direct contradiction to the overall narrative that a recession would be necessary to bring down inflation.

This result stems from the re-emergence of the holy grail of economics – productivity gains. Productivity facilitates economic growth without inflation as you combine resources in more efficient ways than ever before. It can also be associated with higher equilibrium interest rates, since the economy does not depend on low interest rates for growth and prosperity.

Economists generally assume that the growth trend in the United States is about 2 percent, which includes the assumption that productivity will grow about 1.5 percent per year and that population growth will be about 0.5 percent. In the year to September 30, non-farm business sector productivity grew by 2.2 percent after a dismal performance the previous year, double the trend over the 10 years before the pandemic of just 1.1 percent annually.

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Some of the rebound can be attributed to the recovery of global supply chain operations. Frictions related to the pandemic were a major source of sand in business operations in 2021 and 2022 and inflation in the prices of consumer and industrial goods. This year witnessed a rapid return to normalcy in supply chain operations and an accompanying decline in commodity inflation. This source of productivity improvement may be short-lived, because the recovery of supply chains will not continue to reduce unit production costs.

The real question is whether productivity can continue to grow at a healthy pace. There are two reasons to believe that productivity performance could improve after the lackluster performance following the financial crisis of 2008-2009.

The first concerns the rapid recovery of the labor market. Record numbers of people have left their jobs in the past few years. This has been a challenge for businesses, but quitting rates are back down towards pre-pandemic levels, which could provide a boost to productivity in the near term as the costs of hiring and training new workers fall.

The volatility of workers in recent years can also hurt long-term profits because it may mean that workers are matched with more suitable employers. In a recent Conference Board poll, 62.3 percent of American workers said they were satisfied with their jobs in 2022 — up from 60.2 percent in 2021 and the highest level recorded since the survey began in 1987.

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Another byproduct of the hot labor market — as well as the unique operational challenges of the pandemic — is that we have seen our first recession without an extended decline in business investment, the hallmark of most downturns.

Companies have continued to invest in equipment and intellectual property at a historically high rate to meet remote work needs, as well as offset some of the need for workers amid a very tight labor market.

The technological tools available to companies to re-engineer business processes and achieve efficiencies have arguably never been more abundant. If they achieve anything close to the historical average return on investments made over the past few years, we may be headed for better productivity this cycle.

The evidence will be clear on whether inflation can continue to slow without obvious economic weakness. If we are not on an improving production trend, rates may not stay higher for much longer. Central bankers will have to cut inflation the hard way through a recession that will likely push longer-term interest rates lower at the expense of risky asset prices.

The current constellation of higher, longer-term interest rates and rising house and stock prices is already dependent on a better productivity trend, and there are at least a few reasons for some optimism.

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