Productivity The Federal Reserve’s Fly in the Ointment

Since September 2007 when the Federal Reserve responded to the economic crisis facing the United States by dropping the federal funds rate from 5.25 percent to between 0 and 0.25 percent, the Fed has done its very best to keep the economy running on all cylinders, unfortunately, even with its massive monetary experiment and its bloated balance sheet, there is one aspect of the economy that has not responded as it normally would.

Let’s open with the Bureau of Labor Statistics definition for output per hour.  According to the BLS, labor productivity or real output per hour is calculated by dividing an index of real output by an index of hours worked of all persons including employees, proprietors and unpaid family workers.  Here is a graph from FRED showing the real output per hour of all persons in the nonfarm business sector (i.e. productivity):

As you can see, it appears as though the curve is flattening after the Great Recession, suggesting that productivity growth has declined in comparison to other economic expansions.  This graph showing the year-over-year percentage change in real output shows just how dramatic the slowing in real output has been since the first quarter of 2011:

Other than the short period between the first quarter of 2009 and the first quarter of 2011, productivity growth has been anaemic, particularly when we compare productivity growth levels in the latest period of economic expansion to that of previous expansions.  To that end, here is a bar graph showing the average rate of productivity growth for all periods of economic expansion since 1970:

Even when we include the burst of productivity growth between early 2009 and 2011, productivity growth in the latest expansion shows the lowest average growth rate going back nearly five decades.  If we look at the growth rate of productivity since early 2011, year-over-year growth drops to an extremely low level of 0.54 percent, the slowest productivity growth rate in the past fifty years and only slightly higher than the period between early 1979 and late 1982 when the U.S. economy experienced two short-lived recessions and a 19 percent Federal Funds Rate.

Why has the growth rate of productivity dropped so significantly since the Great Recession?  This can be attributed to several factors:

1.) a lack of business capital investment in new technology.

2.) a drop in the productivity payoff from digital technology.

3.) a lack of training in new skills for workers.

4.) weak demand.

Here is what Stanley Fisher, Vice Chairman of the Federal Reserve had to say about the weakness of productivity growth in late 2016:

Understanding the recent weakness of productivity growth is central to addressing the longer-run challenges confronting the economy. Productivity growth over the past decade has been lackluster by post-World War II standards. Output per hour increased only 1-1/4 percent per year, on average, from 2006 to 2015, compared with its long-run average of 2-1/2 percent from 1949 to 2005. This halving of productivity growth, if it were to persist, would have wide-ranging consequences for living standards, wage growth, and economic policy more broadly. A number of explanations have been offered for the decline in productivity growth, including mismeasurement in the official statistics, depressed capital investment, and a falloff in business dynamism, with reality likely reflecting some combination of all of these factors and more.

We should also consider the possibility that weak demand has played a role in holding back productivity growth, although standard economic textbooks generally trace a path from productivity growth to demand rather than vice versa. Chair Yellen recently spoke on the influence of demand on aggregate supply.3 In her speech, she reviewed a body of literature that suggests that demand conditions can have persistent effects on supply.  In most of the literature, these effects are thought to occur through hysteresis in labor markets. But there are likely also some channels through which low aggregate demand could affect productivity, perhaps by lowering research-and-development spending or decreasing the pace of firm formation and innovation. I believe that the relationship between productivity growth and the strength of aggregate demand is an area where further research is required.

I will conclude by reiterating one aspect of the low interest rate and low productivity growth problems that I have mentioned previously–the fact that, for several years, the Fed has been close to being “the only game in town,” as Mohamed El-Erian described it in his recent book.5 But macroeconomic policy does not have to be confined to monetary policy. Certain fiscal policies, particularly those that increase productivity, can increase the potential of the economy and help confront some of our longer-term economic challenges. While there is disagreement about what the most effective policies would be, some combination of improved public infrastructure, better education, more encouragement for private investment, and more effective regulation all likely have a role to play in promoting faster growth of productivity and living standards. By raising equilibrium interest rates, such policies may also reduce the probability that the economy, and the Federal Reserve, will have to contend more than is necessary with the effective lower bound on interest rates.” (my bold)

Basically, the Federal Reserve has no real idea on how to improve productivity growth levels.  One thing that they do seem to acknowledge is that slowing productivity will have a long-term impact on profit growth, living standards, wage growth and future economic policies.  This will obviously pose long-term challenges for the American economy, particularly during the recovery period after the next economic contraction.  If we think that the economy has not grown at levels seen in past recessions since the Great Recession, dropping productivity growth levels will make the next recovery look like it is barely a recovery at all.

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