Implications of Productivity Uncertainty For Monetary Policy

Business Economics, Jan, 2000 by Robert T. Parry

UNCERTAIN FUTURE PRODUCTIVITY GROWTH COMPLICATES MONETARY POLICY IN A LOW-INFLATION, LOW-UNEMPLOYMENT ECONOMY.

Faster productivity growth rates are consistent with the remarkable combination of fast GDP growth, low unemployment, and low inflation the U.S. economy has enjoyed recently. Yet there are uncertainties about this productivity growth, not only because of measurement problems, but, more fundamentally, because one cannot tell at this early stage whether the productivity surge is a cause or a result of today's fast output growth, and, if it's a cause, how long it will last. These uncertainties complicate the question of where the Fed should be along the spectrum of more pre-emptive action or more cautious action.

I have been asked to address "risks in the economic outlook." My focus will be broad and long-run, and I believe that late in 1999 is an especially good time to do this.

As you know, the last three years have been very good years for the economy. But they haven't been such great years for a lot of forecasters. Frankly, for much of that time, many of our forecasts predicted that the combination of fast growth, low unemployment, and low inflation was about to end any minute.

And it's easy to understand why. It was natural to assume that there was little change in the structure of the economy. So it also was natural to assume that economic performance would return to historical norms. Over the last three years or so, that left most forecasts centered on a real GDP growth rate of two percent or a little higher, which was thought to be the long-run trend. Specifically, the median one-year-ahead forecasts from the Blue Chip survey were 2.1 percent in January 1996, 2.1 percent in January 1997, and 2.2 percent January 1998. But, in fact, the actual rates were almost twice that! At the same time, with the economy growing rapidly and labor markets apparently tight, most forecasts overshot actual inflation in 1997 and 1998. For example, the Blue Chip survey showed Consumer Price Index (CPI) inflation of 2.9 and 2.3 percent in 1997 and 1998, respectively, versus actual figures of 1.9 and 1.5 percent.

In these remarks, I want to focus on what these forecast errors could be telling us about the current economy. And I'll also discuss what the errors mean for the conduct of monetary policy.

What Has Been Driving the High-Growth, Low-Inflation Economy?

So, let me turn to the first issue--what could be going on in the economy that would be consistent with fast output growth, low unemployment, and low inflation? Well, I can point to several special factors that have helped keep inflation down during this period. For example, global financial crises weakened foreign demand. That led to a stronger dollar--and therefore lower import prices--as well as falling commodity prices worldwide and a drop in capacity utilization rates in U.S. manufacturing. In addition, energy prices were falling during 1997 and 1998, and so were the costs of health care, as the industry restructured itself. Finally, there's a technical point: the CPI is down 1/2 percent or a bit more because of the improvements the Bureau of Labor Statistics has made in measuring prices.

But beyond these special factors, there's a more fundamental issue: the nation's productivity. Certainly, several developments in the last couple of years suggest that we may be in the midst of a supply shock related to more rapid, and more dispersed, technological change. And that would be consistent with the fast growth, low unemployment, and low inflation we've seen. One obvious indicator is that measured productivity growth has picked up--rising to just under 2-1/2 percent on average. This compares to an estimated trend rate of only around 1 to 1-1/2 percent for the 1980s and the first half of the 1990s. Another indicator is the faster growth we've seen in real labor compensation. This result is something we'd expect to go along with higher labor productivity. A third indicator is the strength of corporate profits. This also can help explain at least part of the extraordinary rise in stock market values.

And it's easy to see why people would point to technological advances as the source of much of this increase in productivity growth rates. For one thing, we've seen very rapid increases in investment in computers and other information processing equipment--since 1995, it has ranged from just under twenty percent a year to over thirty percent a year, in real terms! For another, there are plenty of examples of the difference technology can make--not only in labor-saving devices, but also in changing the way people do business. For example, I saw firsthand how technology could increase the flexibility of production processes when I visited a lumber mill in Oregon. They demonstrated how they used lasers to define the geometry of a log. They then cut it based on the latest price information for different cuts. If there's a shortage of two-by-fours, then prices on them rise and the mill cuts more of them and fewer of other sizes.