Productivity adds the anesthetic to Powell's pain-free disinflation
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[November 03, 2023] By
Howard Schneider
WASHINGTON (Reuters) - A recent surge in U.S. productivity has
underscored Federal Reserve Chair Jerome Powell's emerging narrative for
how inflation may continue to decline even amidst sustained job and
economic growth.
The best-of-both-worlds outcome would rely on the U.S. finding a new
balance between the demand for and the supply of goods and services less
by "destroying" demand - the way Fed interest rate increases typically
play out - and more through improvements in the economy's capacity.
In what has been a somewhat unheralded surprise, that is what has been
unfolding through both improvements in the number of people willing to
work, including new immigrants, and also through improvements in how
much each worker produces, a dynamic that lowers effective labor costs
even if wages are higher.
New data released Wednesday showed productivity grew an outsized 4.7% in
the third quarter, the largest increase in three years and the second
large gain this year. That caused unit labor costs to fall at a 0.8%
annualized rate.
The net result is higher potential output with less inflationary risk,
something Powell pointed to on Wednesday in his most extensive comments
to date on the possibility that for the moment at least the economy may
have an enhanced ability to grow, add jobs, and raise wages without
adding to inflation.
The October employment report due on Friday at 8:30 EDT (1230 GMT) will
provide updated estimates of the size of the labor force, a critical
piece of the puzzle. After stalling through much of 2022, the workforce
grew by 3 million workers, or about 2%, in the nine months through
September.
The dynamic is one reason why the Fed kept its policy interest rate on
hold at 5.25%-5.50% at its meeting this week despite recent data showing
the economy grew at a 4.9% annualized rate in the third quarter - far
beyond the 1.8% rate Fed officials see as the underlying long-term,
noninflationary trend.
Throughout the pandemic era growth has largely exceeded that rate even
as inflation has continued to fall, and Powell at his post-meeting press
conference on Wednesday tried to square the circle.
"People think trend growth over a long period of time is a little less
than 2%," Powell said. But "potential growth is elevated for a year or
two right now over its trend level...you're seeing actually elevated
potential growth, catch up growth, that can happen" because of
improvements in things like labor supply that, all things equal, allow
the economy to grow faster without the same price pressures. Along with
more people working, productivity adds a boost as well.
CAN IT LAST?
Higher potential growth provides more leeway for the economy to grow
without the Fed worrying about the impact on prices. In other words, it
offers a wider runway for the "soft landing" Fed officials have hoped to
engineer with inflation falling but the economy largely left on track.
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A job seeker leaves the job fair for airport related employment at
Logan International Airport in Boston, Massachusetts, U.S., December
7, 2021. REUTERS/Brian Snyder
Rising productivity "signals receding inflationary pressure even as
the economy continues to display notable resilience," said EY Senior
Economist Lydia Boussour. "If companies can generate strong
productivity growth, they will not be so inclined to pass elevated
input costs onto consumers."
The Fed's situation mimics in some ways the mid-1990s, when Alan
Greenspan - the central bank's chief at the time - resisted pressure
to raise interest rates, arguing that rising productivity would let
the economy grow with less inflation, an insight credited with
keeping that decade's strong economic performance on track.
The spread of Web-based technologies was still in its relative
infancy then, and the years since have produced not only more
tempered productivity numbers, but a generally dismal assessment
that trend growth in output per worker hour was only around 1.5%.
That, coupled with sluggish population growth, is the reason Fed
officials in recent years have steadily downgraded their view of the
long-term trend growth in overall economic output, with the median
fixed at around 1.8% since 2016.
Powell and his colleagues must now decide just how sustainable the
recent improvements are.
The upside, as Powell described it, is the possibility of a virtuous
cycle developing in which jobs remain plentiful, wages grow, and the
economy continues to expand - all with a steady "disinflation" as
the pace of price pressures fall back to 2%.
"The dynamic has been really strong job creation, with wages that
are higher than inflation...and that raises real disposable income,
that raises spending, which continues to drive more hiring," Powell
said. "It has been good. And the thing is, we've been achieving
progress on inflation in the middle of this.
"The question is, how long can that continue?"
If and when it stops, the Fed may face the tougher choice of just
how much the economy - the demand side at least - needs to slow to
keep inflation in line.
"Growth is going to be slower this quarter...Higher rates are
dampening activity here and there," wrote TSLombard Chief U.S.
Economist Steven Blitz. But "if real growth continues apace,
disinflation runs its course and enough inflation eventually returns
to pull the Fed back into a tightening cycle."
(Reporting by Howard Schneider; Editing by Dan Burns and Andrea
Ricci)
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