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U.S. Productivity Improves: Good News for Inflation, Interest Rates and Stocks

Prof. Peter Morici - 9/6/2007

Today, the Department of Labor reported productivity in the nonfarm private business sector increased at a 2.6 percent annual rate in the second quarter of 2007. This was significantly higher than the 0.7 percent increase recorded in the second quarter of 2007.

Since the second quarter of 2006, productivity advanced only 0.9 percent, and this is less than in recent years. However, the second quarter of 2006 was an particularly strong quarter for productivity and provides a poor benchmark. Year over year results will be stronger for the third quarter of 2007.

The housing slump and higher energy prices have slowed sales of building materials, automobiles, construction equipments, and their supplying and distributing industries. Businesses have accepted a somewhat slower pace of productivity advance to avoid laying off workers. This is a well-reasoned response, because forecasters expect growth to pick up by mid-2008, and the processes of laying-off and rehiring are expensive.

Labor Costs, Inflation and the Stock Market

Hourly compensation increased 4.1 percent in first quarter, and unit labor costs, which factors in higher wages and higher productivity, rose 1.4 percent. Labor costs pose no threat to accelerate inflation, and these likely reflect the tighter labor market of 2006, before the subprime crisis began to bite. These wage increases should not constrain Federal Reserve interest rate setting policy.

Prospects for inflation remain mostly determined by foreign oil prices, inflation in China, which supplies a significant share of U.S. consumer goods, and the value of the dollar against the euro and other non-Asia currencies. A significant revaluation of the dollar against the yuan, with other Asian currencies following in trail, would do much to abate global inflation.

At its September 18 interest rate setting meeting, the Federal Reserve will weigh the impact of the subprime crisis on consumer spending, for example for automobiles and other durable goods. Market expectations point to a cut in the Federal Funds rate to 5.00 percent from the current 5.25 percent.

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, steady or falling interest rates, productivity gains and new products, and profits from overseas operations should help push stock prices higher.

Better Productivity Growth Ahead?

U.S. companies continue to bang out new products and more efficient methods for making goods and services. In the second quarter, manufacturing productivity is up 1.8 percent. In the critical durable goods sector, which builds out many of the breakthroughs in information technology, productivity was up 4.7 percent. In addition, biotechnology is driving profit growth in the agribusinesses, like Monsanto.

These trends indicate U.S. durable goods manufacturers and technology-based services should be gaining global market share. But for the China’s undervalued yuan, U.S. durable goods manufacturers would not be losing market share and jobs to Asian competitors, and but for arbitrary restrictions on U.S. investment, the presence of U.S. services providers in China should be larger.

Productivity should improve as personal consumption expenditures and business investment drive up the demand for U.S. goods and services in the first half of 2008. Factoring in a one percent annual increase in the labor force, the economy could grow 3.5 to 4 percent a year with the right mix of fiscal, monetary and exchange rate policies.

The overvalued dollar 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 percent per year, and raise potential GDP growth to about 4 percent.