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:
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
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
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
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
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.