Smith Faculty Opinion Article

By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

August 8, 2008

U.S. Productivity Advances 2.2 Percent: Good News for Inflation, Interest Rates and Economy

Today, the Department of Labor reported productivity in the nonfarm private business sector increased at a 2.2 percent annual rate in the second quarter of 2008. This was a very good showing the middle of an economic slowdown, and in line with the 2.6 percent increase recorded in the first quarter of 2008.

Productivity did fall 1.4 percent in the manufacturing sector. Those losses were mostly concentrated in the durable goods sector. The downsizing of the automobile sector and slowing growth of capital goods exports the first half of this year may have resulted in a temporary downshift. Productivity growth has been very strong in recent quarters in manufacturing, especially for durable goods, and one or two quarters of adjustments may be expected as the auto sector, in particular, reorganizes.

Continued strong productivity growth helps limit inflation in check in the face of rising oil and commodity prices, and accommodates moderate wage growth.

The Federal Reserve can focus on the subprime crisis and stabilizing credit markets, without fear of creating inflationary pressures beyond those imposed by international oil and commodity markets. Those pressures are little affected by Federal Reserve actions.

The Federal Reserve expects inflationary pressures to abate by the end of 2008. The veracity of that forecast will hinge on global developments in oil and commodity markets and not be much affected by Federal Reserve actions. Oil prices have been receding in recent weeks, and demand pressures on available supplies of other commodities should ease as growth slows in the U.S. and globally over the balance of 2008 and 2009.

Credit markets are stuck. The major New York banks and primary securities dealers can no longer bundle mortgages and business loans into bonds, because insurance companies, pension funds and other fixed income investors no longer trust Wall Street financial houses. Consequently, regional banks, who rely on New York financial houses to resell their loans, have limited ability to extend credit to qualified home buyers and worthy businesses. To correct this situation, the Federal Reserve needs to take bolder steps than those so far talked about by the Federal Reserve, Treasury and foreign central banks. Robust productivity growth give the Federal Reserve needed room to act much more decisively.

Labor Costs, Inflation and the Stock Market

Hourly compensation increased at a 3.6 percent annual rate in the third quarter, and unit labor costs, which factor together higher wages and productivity, increased 1.3 percent. Strong productivity growth permitted moderate wage increases, and these pose no significant threat to accelerate inflation. Thanks to rising productivity, wage pressures should not constrain Federal Reserve interest rate setting policy.

Prospects for inflation remain mostly determined by foreign oil and commodity prices, and cost pressures in China’s manufacturing, which supplies a significant share of U.S. consumer goods. A significant revaluation of the yuan against the dollar would reduce pressures both on global oil supplies and wages in Chinese manufacturing, and do much to constrain global inflation.

At its September policy setting meeting, the Federal Reserve will weigh the impact of the subprime crisis on the housing market and broader economy. Observers expect the Fed to keep the target federal funds rate at 2.0 percent until after the November election. This new productivity data, along with subdued wage increases, indicate the Fed may keep interest rates steady for the balance of 2008 and early 2009.

Productivity growth fuels corporate profits by permitting U.S. businesses to maintain or widen margins on domestic operations. Also, U.S. businesses are taking their innovations abroad, and foreign operations account for significant shares of U.S. corporate sales and profits.

Overall, falling interest rates, productivity gains and new products, and profits from overseas operations should help support stock prices. The stock market will remain volatile but should trend upward through the balance of 2008.

Better Productivity Growth Ahead?

Productivity should continue to advance, and looking beyond the adjustments associated with the subprime crisis, the growth potential for the U.S. economy remains formidable. Factoring in a one percent annual increase in the labor force, the economy could grow 4 to 4.5 percent a year with appropriate Federal Reserve and Treasury policies to reform Wall Street Banks and securities dealers, and the right mix of fiscal, monetary and exchange rate policies.

The overvalued dollar against the Chinese yuan, Japanese yen and other Asian currencies limits productivity gains, because the resulting trade deficit shifts labor and capital from export and import-competing industries into other non-trade-competing activities. Trade-competing industries exhibit 50 percent higher labor productivity and spend much more on R&D than do the rest of the economy.

Also, the trade deficit shifts the production of new and innovative products offshore, reducing high-value employment immediately and increasing the likelihood that next generation products will be developed, as well as made, abroad.

Cutting the trade deficit in half would boost R&D spending enough to push sustainable productivity growth to about 3 to 3.5 percent per year, and raise potential GDP growth to about 4 to 4.5 percent. 

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.