Smith Faculty Opinion Article

May 7, 2008

By Dr. Peter Morici, Professor of International Business
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 Peter Morici

U.S. Productivity Advances 1.9 Percent
Good News for Inflation, Interest Rates and Stock Prices

Today, the Department of Labor reported productivity in the nonfarm private business sector increased at a 2.2 percent annual rate in the first quarter of 2008. The consensus forecast was 1.5 percent, and my published forecast was 2.0 percent.

Since the third quarter of 2006, productivity has advanced 2.5 percent, and remains quite strong in the critical manufacturing sector.

Continued strong productivity growth helps keep inflation in check in the face of rising oil and commodity prices, and accommodates moderate wage growth.

The Federal Reserve can focus on the subprime crisis and stabilizing credit markets, without fear of creating inflation pressures beyond those imposed by international oil and commodity markets and outside the effect of Federal Reserve actions.

Federal Reserve forecasts indicate inflationary pressures should abate in the months ahead. The veracity of those forecasts will hinge on global developments and not be much affected by Federal Reserve actions

Credit markets are stuck. The major New York banks and primary securities dealers can no longer bundle mortgages and business loans into bonds, because insurance companies, pension funds and other fixed income investors no longer trust Wall Street financial houses. Consequently, regional banks, who rely on New York financial houses to resell their loans, have limited ability to extend credit to qualified home buyers and worthy businesses. To correct this situation, the Federal Reserve needs to take bolder steps than those so far talked about by the Federal Reserve, Treasury and foreign central banks. Robust productivity growth give the Federal Reserve needed room to act much more decisively.

Labor Costs, Inflation and the Stock Market

Hourly compensation increased at a 4.2 percent annual rate in the first quarter, and unit labor costs, which factor together higher wages and productivity, increased 2.2 percent.

Productivity growth will remain strong in the second quarter, while wage pressures are moderating. Strong productivity growth permits moderate wage increases that pose no significant threat to accelerate inflation. Thanks to rising productivity, wage pressures should not constrain Federal Reserve interest rate setting policy.

Prospects for inflation remain mostly determined by foreign oil prices, and cost pressures in China’s manufacturing, which supplies a significant share of U.S. consumer goods. A significant revaluation of the yuan against the dollar would reduce pressures both on global oil supplies and wages in Chinese manufacturing, and do much to constrain global inflation.

At its June policy setting meeting, the Federal Reserve will weigh the impact of the subprime crisis on the housing market and broader economy. Observers expect the Fed to keep the target federal funds rate at 2.0 percent, but today’s productivity data give the Fed latitude to further reduce interest rates if economic conditions warrant.

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, falling interest rates, productivity gains and new products, and profits from overseas operations should help support stock prices. The stock market will remain volatile but should trend upward overall, especially in the second half of 2008.

Better Productivity Growth Ahead?

U.S. companies continue to bang out new products and more efficient methods for making goods and services. In the first quarter, manufacturing productivity was up 4.1 percent and at a 3.7 percent rate since the third quarter of 2006. In the critical durable goods sector, which builds out many of the breakthroughs in information technology, productivity was up at a 4.5 percent annual rate since the third quarter of 2006.

These trends indicate U.S. durable goods manufacturers and technology-based services should be gaining global market share. But for 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 continue to advance, and looking beyond the adjustments associated with the subprime crisis, the growth potential for the U.S. economy remains formidable. Factoring in a one percent annual increase in the labor force, the economy could grow 4 percent a year with appropriate Federal Reserve and Treasury policies to reform Wall Street Banks and securities dealers, and the right mix of fiscal, monetary and exchange rate policies.

The overvalued dollar against the Chinese yuan, Japanese yen and other Asian currencies 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.

Peter Morici is a professor at the Robert H. Smith School of Business and former Chief Economist at the U.S. International Trade Commission.                                                          ►More Faculty Opinion Articles