Making a Production out of Productivity Increases

Squaring up the New Era version of the economy with the real thing.
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Hey. Drinks Are on Me.

JACKSON HOLE, Wyo. -- The economy has a capacity to grow over time that is limited by the sum of the trend rate of growth in the labor force and the trend rate of growth in labor

productivity

.

In other words, trend

gross domestic product

growth equals trend labor-force growth plus trend productivity growth.

This is terribly important to understand, for it speaks to the whole New Era debate. Trend labor-force growth, for example, sits at roughly 1.3%. So, if the investment boom that began in 1993 has permanently driven trend productivity to 3% from 1.1% during the 1980s, as New Era types contend, then from here on out the economy can grow at a rate as big as 4.3% (1.3% plus 3%) without bumping up against capacity constraints that would produce price pressure.

Again, this is terribly important to understand: If the New Era description of today's economy is the right one, then we will not see the core (excluding food and energy) price measures accelerate. Economic growth has averaged a huge 4.1% lately, but if trend productivity growth has moved permanently to 3% (or more), then there is no reason at all that the core price measures should accelerate. (One could reasonably extend this analysis to mean that, as long as that is the case, the

Fed

will never have a reason to tighten and that market rates are headed materially lower, which is precisely what New Era types are forecasting right now.)

Cool?

OK. Enough background.

Today the

BLS

released first-quarter 1999 productivity and labor-cost numbers for the nonfarm business

sector and full-year 1998 productivity and labor-cost numbers for nonfinancial

corporations. Both sets appear below.

Keep in mind that productivity is defined as output per hour of all persons. Last year in the nonfarm business sector (see table above), for example, a 4.6% increase in output less a 2.4% increase in hours yielded a 2.2% increase in productivity. (Also note that subtracting labor costs from compensation produces the same result, and that not all calculations are precise due to rounding.)

Numbers released today revealed that productivity in this sector accelerated to a 2.8% year-on-year rate during the first quarter; they also revealed that unit labor costs decelerated to a 1.3% year-on-year rate during the first quarter from 2% last year.

Productivity in the nonfinancial corporate sector, meanwhile (see table above), accelerated to 3% in 1998 from 2.5% in 1997.

And that news is just plain good; bigger productivity numbers are just plain bullish.

So why are bonds not rallying a point or two?

Your narrator ventures three guesses.

Greenspan is known to strongly prefer the productivity and cost numbers from nonfinancial corporations to the numbers from the nonfarm business sector.

As such, the fact that unit labor costs in the nonfarm business sector showed deceleration during the first quarter means little; it provides no comfort. Indeed, in terms of the

Fed

policy equation, the first table presented above is arguably even more worthless than the

Beige Book

.

Bond traders are not stupid.

Most forecasters, especially those of the New-Era ilk, forget the following key passage of a speech that G. Love gave back in October.

From the point of view of doing an evaluation of inflation, we don't care about average hourly earnings (from the employment report) or the employment cost index measure of wages and salaries because ultimately it is unit labor costs that matter. And here the data are probably better than any measure of average hourly labor costs.

This is a terribly important point. Twice recently -- once on the release of the ECI on April 29 and again on the release of employment on May 7 -- you heard New Era types harping on the fact that the measure of wages contained in both of those reports was decelerating. This, they claimed, represents proof that the New Era is here: The

unemployment rate

keeps falling, but wage growth is decelerating. The rules have changed for good.

Uhh ... no. They haven't. That line of thinking would have caused you to miss lots of boats since October, and if you keep listening to it, you'll miss scores more still. The measure of compensation listed in the nonfinancial-corporations table above is the one that G. Love is looking at; it's the one that perfectly tracks (inversely, of course) the downward trend we've seen in the jobless rate; and it's the one that includes stock options and squares with what we know is happening to wage growth in the real world.

And that leads to the next point:

The market is looking ahead.

Is productivity still accelerating right now? The numbers say it is. Are labor costs threatening? Hardly. They've accelerated for two straight years, but still they're running at just a 1.1% pace.

But recall the following Greenspan nugget.

Finally, while it is reasonable to conclude that some of the gains in output per hour (productivity) have been driven by fundamental forces, and are not only a cyclical phenomenon or a statistical aberration, it remains a wholly separate question of whether they can be extended. The rate of growth of productivity cannot increase indefinitely. While there appears to be considerable expectation in the business community, and possibly Wall Street, that the productivity acceleration has not yet peaked, history advises caution. ... For, if productivity growth should level out or actually falter because additional technology synergies fail to materialize, or because output per hour has been less tied to technology in the first place, inflationary pressures could re-emerge, possibly faster than some currently perceive feasible.

The risk is that productivity growth is currently leveling out (at best); that the productivity acceleration we have seen since 1996 will turn out to be mostly cyclical, not structural, and that it will slow materially if and when overall economic growth does.

And on that score, recall that it took only four quarters for productivity to decelerate a full three-and-a-half percentage points during the advanced stages of the 1961-1969 boom, the expansion that most closely resembles the one we've been riding since 1991.

Lots of people reckoned that productivity was a panacea back then, too.

Anyway.

Let's go get drunk.

Side Dish

All apologies yet again for not being able to respond to all of the mail.

Say you're a stock-picker. Say you're also far and away one of the loudest and most omnipresent stock pickers on the Street. And say finally that a monkey with a buy book could have trounced your 1998 performance by 30 percentage points.

Now.

Would that not humble you enough to make you think that maybe you ought to tone it down a bit? For at least the next year or so?

Sheesh. What passes for commentary these days. And Kansas? The price of a haircut at the barbershop here in town just soared to $11 from $9. So put that in your price pipe and smoke it.

Ugh. I could have gone to a fancy university had my high-school teachers graded as easy as you guys.

Uhh ... hey. Keep in mind that this column is primarily about the economy and secondarily about the bond market. But not at all about shares. That's what the rest of the site's for. The only thing I know about shares is that they're going to appreciate an average 30% per year for the rest of my life.