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|  | DECEMBER 28, 2005
By Michael Wallace The Shrinking Productivity FactorWhy did outgoing Federal Reserve Chairman Alan Greenspan recently neglect to mention productivity growth? Because it has seen its greatest gainsMuch of the focus on the last Federal Reserve statement on Dec. 13 was leveled on the removal of the "accommodation" reference. Yet there was another omission that flew silently under the radar screen: "robust underlying growth in productivity." As we asserted in our review of the statement, this may have simply been a housekeeping measure aimed at handing over a lean and unburdened statement to the next Fed chairman (see BW Online, 12/14/05, "Between the Fed's Fewer Lines"). Or it could have been a deliberate act with wider policy implications. "CREATIVE DESTRUCTION." The Fed first elevated the integral role productivity played in the extraordinary decadelong run of noninflationary growth that began in the early 1990s, in the wake of Chairman Alan Greenspan's seminal speech on the topic. In his Sept. 4, 1998, tome, Question: Is There a New Economy?, Greenspan introspectively considered his views on the new economic paradigm for the first time. More like a psychoanalyst than a central banker, he couched his qualified praise for the adoption of productivity-enhancing technologies and methods with the underlying premise that human nature ensures that history is destined to repeat itself -- what appears new may really only be an extension of the past. Yet he appeared to grudgingly accept that something exceptional was going on, which tempered his past reservations about "irrational exuberance," making his now-famous reference to Joseph Schumpeter's "creative destruction" theory. Several months later, the concept was given greater stature by its appearance in the May 18, 1999, Federal Open Market Committee statement, which referenced "productivity gains" as part of the policy equation. This elastic phrase was expanded, shrunk, and sometimes dropped for a month or so, but managed to survive the tech-sector crash, September 11, corporate-governance scandals, and even hurricanes -- until now. SOLID GDP GAINS. It even grew in importance to become a virtual crutch for the economy in the Fed's eyes, used to reassure the public that the economy was still on track. Productivity could help the country to weather grief and adversity. As the Nov. 6, 2001, statement reveals: "Although the necessary reallocation of resources to enhance security may restrain advances in productivity for a time, the long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate." Most recently, the Richmond Fed president, Jeffrey Lacker, asserted in his Dec. 22, 2005, speech on the "Economic Outlook for 2006" that after core investment in information and communications technologies in the late 1990s, a secondary phase of total "multifactor" productivity gains has since been achieved by exploiting and redeploying existing technologies more efficiently. Lacker concludes that productivity growth may continue to exceed 2.5%, as compared to average rates in excess of 3.4% around the turn of the millennium, and rates in excess of 6% in late 2003. It would appear from his perspective that productivity may play a less pronounced, but still significant, role in low-inflationary growth. Over the near term, nonfarm productivity growth is expected to slow to a 1.5% rate in the fourth quarter, following the 4.7% surge in the third quarter, with the lull due to the hurricane-depressed slowdown in gross domestic product growth to the 2.7% area on the quarter. But beyond that, we expect solid GDP gains through the first half of the new year to place continued upward pressure on productivity growth, with likely gains in the 2%-to-4% range in the first and second quarters that will carry the robust trend in productivity growth well past the end of Greenspan's term. EMPLOYMENT'S IMPORTANCE. In addition, seasonal patterns suggest notable upside risk in fourth-quarter hourly compensation growth, which we expect at 4.5% vs. the 3.7% gain in the third quarter. The result should be an upward bump in unit-labor cost growth to the 3% area in the fourth quarter, and likely continued upward pressure on this measure, as we enter the new year, that will also extend this normal cyclical pattern in labor costs. The upcoming December employment report could take on increased importance at a time when the Fed has apparently moved toward a more neutral policy footing, with the removal of "accommodative" from the policy statement, and is in transition to new leadership. Faster employment growth could take the edge off of the robust trajectory in productivity growth, at least through the first half of 2006. We expect nonfarm payrolls to post a hefty 230,000 gain in December, with above-trend gains through at least the first quarter, as hurricane-displaced workers gradually reappear in the employment figures. Labor costs in the monthly employment report, as gauged by hourly earnings, will likely increase by 0.2% in December, which is consistent with the modest trend in wage costs in this cycle, from the low 2% area in early 2004 to more than 3.2% year-over-year now. In "real" or inflation-adjusted terms, hourly earnings remain deep in negative territory, in the vicinity of drops of 2% year-over-year, due to the sustained sizable increases in headline inflation that have been led by firmness in energy prices. WHO GETS WHAT. Though recession fears have dissipated, now that recovery from the hurricane episode has clearly emerged in reported data, the economic cycle is continuing to mature. This will sharpen the debate regarding the structural-vs.-cyclical nature of recent productivity growth strength through 2006. New-paradigmers see productivity strength as mostly structural, while skeptics see it as mostly cyclical, or a reflection of measurement error. In his Joint Economic Committee testimony in June, Greenspan addressed the risks of rising unit-labor costs, and seemed to suggest that "slower growth of output per hour" was a factor. Just how increasing corporate profit margins and pricing power in 2004-05 are sliced up between labor and management ahead could dictate whether rising labor costs feed back into core prices. LEVEL PLAYING FIELD. By unburdening Bernanke of any reference to "robust productivity" levels in the statement, Greenspan appears to have created some breathing space for a fresh assessment of productivity trends, risks from rising labor costs, and how these factors will play out beginning in 2006. With a likely 350 basis points in policy tightening over the course of the cycle through this term, and a leaner policy statement, Greenspan has created a level playing field for Bernanke. We'll have to wait to see whether the new chairman decides to endorse the new productivity paradigm, as Greenspan did, or chart a fresh course on the topic.  Wallace is global market strategist for Action Economics
BW MALL
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