MNI INTERVIEW: US Productivity Boom Can Mask Price Pressures

The Federal Reserve appears appropriately wary of counting on the recent U.S. productivity boom to deliver faster growth and contain inflation, as price pressures will reemerge once productivity growth inevitably tapers off, Evan Koenig, former principal policy adviser at the Dallas Fed, told MNI.

Rising productivity growth as supply chains heal and firms adjust to fewer workers allows the Fed to deliver low unemployment, higher wages and faster growth by offsetting the inflationary effects of tight labor markets. Artificial intelligence could continue to enhance productivity over the long run. But productivity gains can’t protect the economy indefinitely against inflation, he said.

With trend inflation still running above target at around 3%, the Fed will reduce short rates slowly and only as long as data continue to show demand and labor market tightness easing, Koenig said in an interview.

"A spurt of productivity growth like we had last year can disguise inflation pressures that are lurking under the surface," he said. "It only holds down unit labor costs while productivity growth is picking up. Once it levels off, the buffer between wage pressure and unit labor costs disappears. If that spurt now slows, you can be in a stagflation situation where you can see a pickup in inflation pressures even in a loose labor market."

'90S BOOM

U.S. productivity rose 2.6% in the fourth quarter of 2023 from a year ago, compared to 1.6% in the same quarter in 2019. Output per hour worked has added more than 6% in the nonfarm business sector since 2019, according to the Bureau of Labor Statistics.

That improvement has helped the Fed steer the economy into a soft landing. GDP growth for 2023 as a whole was 3.1%. The unemployment rate has stayed under 4% and inflation fell to 2.4% in January from 5.5% a year earlier. Trend U.S. growth is generally estimated to be 2% -- 0.5 pp of which is labor supply growth and the other 1.5 pp productivity growth.

A comparison with the 1990s productivity boom offers reasons to be cautious, Koenig said. The IT revolution delivered several years of low unemployment accompanied by low inflation -- but ever higher rates of productivity growth were ultimately unsustainable.

"In the late '90s, there was lots of talk about the new economy and how old speed limits don’t apply," he said. "To some extent there was an acceleration in productivity growth that lasted several years, and it did break the link between tight labor markets and upward pressures on price inflation."

But unlike in the '90s, when inflation was quite low, today it is higher than desired and there's little room to experiment to see if price pressures emerge, especially as productivity data are known to be noisy and subject to revision, Koenig said.

DEMAND TOO HOT

Measures of underlying price pressures, including the Dallas Fed trimmed mean PCE and Cleveland Fed median CPI, indicate inflation is heading south but still running higher than the BLS's figures. Aggregate weekly payrolls -- the total amount firms are paying in wages and an indicator of nominal demand growth -- are also rising just above 5% on a six-month and 12-month basis, consistent with trend inflation of 3%, Koenig noted.

The trimmed-mean inflation rate has a fairly reliable and tight relationship to labor market slack, and the labor market is still tight, he said. The unemployment rate ticked higher last month but remains below 4%, and the vacancy rate has leveled off, albeit at a historically high level. A resumption of that decline would be encouraging, he said.

"The Fed's baseline should be a slow reduction in short rates, and the actual pace depends on the data that come in," he said. "I would be looking for signs of deceleration in nominal demand growth. There’s not much there yet." (See MNI INTERVIEW: No Fed Cuts Until H2, Ex-KC Fed's Hoenig Says)