The productivity watch
The nirvana of high growth and low inflation may be over, Daniel Gross writes in Fortune.
By Daniel Gross

(Fortune Magazine) -- At 2 p.m. on Aug. 8, the Federal Reserve declared a cease-fire in its long-running rate-hike campaign. A week later the government reported benign inflation figures for July: The producer price index rose a meager 0.1 percent, while the core consumer price index was up just 0.2 percent.

Investors and Fed watchers concluded that inflation is under control. And newly confident in the sound judgment of Federal Reserve chairman Ben Bernanke, they began spinning happy scenarios of a soft landing.

Fed policy-makers are hoping the cooling economy will stamp out inflation. But what if they're wrong? (more)

But less noticed on Aug. 8 was the first dissent of the Bernanke era: Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond, voted for a 25-basis-point increase.

He may have been reacting to a bit of news released just days before - one that may indicate we're in for a bumpy macroeconomic ride. The Bureau of Labor Statistics reported that in the second quarter productivity growth came to a screeching halt, falling to 1.1 percent from 4.3 percent in the first quarter.

Perhaps even more ominous - since quarterly productivity numbers tend to jump around a lot - the Commerce Department in late July revised downward its estimates of productivity growth from 2003 to 2005.

Why does productivity matter? It measures an economy's ability to do more with the same amount of labor and is the best indicator of how fast it can grow without spurring inflation.

Until recently productivity growth was highly cyclical: It would rise sharply at the beginning of an expansion and then slow as labor markets tightened and workers demanded greater compensation. That changed in the 1990s. From the early 1970s until 1995, nonfarm business productivity growth averaged a meager 1.5 percent per year. But between 1995 and 2001, even as the 1990s-era expansion ripened, productivity grew at a remarkable rate: about 2.5 percent per year.

Former Federal Reserve chairman Alan Greenspan explained this anomaly by pointing to a virtuous cycle fueled by information technology. IT investments boosted productivity, which boosted corporate profits, which led to more IT investments, and so on, leading to a nirvana of high growth and low inflation.

This virtuous cycle survived the dot-com meltdown, as productivity growth remained strong in the post-2001 years. In June, speaking at his alma mater, MIT, Bernanke noted that research "suggests that the current productivity revival still has some legs."

Vicious reinforcement

But Bernanke may face a much different inflation vista than Greenspan did. In the 1990s, Europe, Asia, and America took turns growing strongly, so we never had a pervasive global push on prices, says Lakshman Achuthan, managing director of the Economic Cycle Research Institute. Now the world's largest economies have all been expanding for several years, which is pushing up prices for commodities. (Hello, inflation!)

If lower productivity and higher inflation amplify each other - as higher productivity and lower inflation did in the 1990s - we face the risk of a bizarro virtuous circle, says Achuthan: a vicious reinforcement, in which lower productivity drives inflation higher, which in turn drives productivity lower.

The most recent productivity release showed unit labor costs rose 4.2 percent in the second quarter of 2006, up from 2.5 percent in the first quarter.

"These are traditional markers of a cyclical inflation upswing," says Allen Sinai, chief global economist at Decision Economics.

Bernanke himself may be more concerned than he lets on. The Federal Open Market Committee's Delphic communiqué for June 29 contained this sentence: "Ongoing productivity gains have held down the rise in unit labor costs, and inflation expectations remain contained."

In the Aug. 8 missive, that reassuring statement was nowhere to be found.  Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.