November 17, 2004

After yet another increase in over-night interest rate targets by the Federal Reserve this past week, economists and analysts are asking how much inflationary pressure is developing, how rapidly will employment be growing, and how much economic growth can be achieved in the years ahead.  All three of these questions must come to grips with one measure:  productivity. 

Labor productivity is the amount of goods and services a worker creates during an hour of work.  If the value provided is higher than the cost of that hour, then prices can fall and profits can swell.  If not, following a profit squeeze, prices will rise.

In the short run, productivity is the enemy of employment.  If workers are more efficient, then fewer are needed for the same amount of work.  Some labor leaders in the past foolishly thought that by establishing rigid work rules that would not permit much efficiency, jobs could be preserved.  This process still occurs in many European countries and some of America’s older industries. 

In fact, as labor costs rise, profits are squeezed, as in the airline industry, or prices tend to rise.  Either companies fail or customers flee for lower cost providers or alternative products and services.  Indeed, in the long run, the most efficient industries tend to generate the most employment.  This seemingly contradictory result happens because efficiency leads to price relief and to new customers. 

Nevertheless, the slowing of productivity gains from more than 4 percent per year early in this decade to the “slow” 1.9 percent gains in the summer led to stronger job growth.  Hurricanes and fluctuating commodity prices, including petroleum prices, did not allow companies to perform at preferred operating levels.  A faster gain in productivity could be anticipated as some of those problems clear. 

Capital spending, an educated work force, resource management, and even the shuttering of inefficient plants can all contribute to productivity growth.  In manufacturing, plant closings, capital expansion, and resource management may have helped recently.  In the service sector, educated workers, technology embedded in new capital spending and resource management all contributed. 

Can these gains continue?  Obviously, there is a limit to shuttering plants that are not up to snuff.  We already are beginning to see a slowing in the amazing productivity advances in manufacturing.  Some pundits also believe the exploitation of the latest wave of technology is peaking.  Efficiency gains should remain strong, but not as spectacular as in the past few years. 

Resource management has no boundaries.  However, we are paying so much for the managers that risk takers are not getting their share of the enterprise gains.  If this persists, enterprise development will suffer.

In short, except for the flexibility of an educated work force, all the major factors contributing to gains may be peaking.    

My own guess is that our economy probably could increase worker efficiencies by 2.5 percent per year for the remainder of this decade.  If so, what will happen to inflation, employment and growth for the remainder of the decade?

If employment growth intensifies, hourly wage increases will be difficult to hold down.  So far, hourly earnings have trended downward from a high growth rate of 4.1 percent in 2001 to 2.6 percent in the past twelve months.  Unfortunately, benefit costs have been moving in the opposite direction to a 6.8 percent high in the most recent twelve months.  Almost half the increasing labor costs are for benefits, not for wages. 

The most recent three months look more promising for benefit growth.  Hospital fees are growing more slowly and doctors’ fees remain reasonably close to overall inflation.  Pharmaceutical prices are now the major medical cost problem.  Nevertheless, benefit costs grew at only a 4 percent annual rate in the past three months. 

With a little luck, labor costs per hour may rise about 4 percent for the next two years as benefit growth slows and wage growth intensifies.  After that, higher labor costs are likely unless another recession, a collapse in commodity prices, or further personal tax reductions are achieved. 

That means inflation can remain in the 1.5 to 2 percent range that the core rate has generated in the recent past.  A 3 to 3.5 percent overnight interest rate would be most appropriate for that environment.  With employment growth of slightly more than 1 percent, hours only slowly extending, and some further room to lower unemployment, our capacity to grow probably is near 3.7 percent. 

Frankly, with consumer savings unusually low, warehouses restocked, housing growing faster than households and wartime expenditures hopefully peaking, the economy will be hard pressed to achieve that 3.7 percent growth capability.  Then, unemployment will not improve, and could even increase slightly, employment gains would average below 150,000 per month, but inflation would remain tame. 

But all these observations very much depend upon what really happens to productivity

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