FRBSF Economic Letter
2005-04; February 18, 2005
Productivity and Inflation
This Economic Letter is adapted
from remarks by Janet L. Yellen, President and CEO of
Federal Reserve Bank
of San Francisco,
delivered at the Economic Summit at the Stanford Institute for
Economic Policy Research in Palo Alto, California, on February
11, 2005. (See www.frbsf.org/news/speeches/ for full speech text.)
Several recent developments have raised concerns about a productivity
slowdown in the U.S. that could slow economic growth and boost
inflation. For example, after soaring at the astounding rate
of nearly 4-1/2% in 2002, 2003, and the first half of 2004, nonfarm
labor productivity growth slowed to around 1-3/4% in the third
quarter of last year and to only 3/4% in the fourth quarter.
during the last year, quality-adjusted computer prices haven't
fallen as fast as they have for the past decade, which may signal
some slowing of technological innovation in this sector. In addition,
there is some industry opinion that the pace of software development
is beginning to slow.
Though these developments give us ample
reason to think seriously about what the future may hold for
productivity growth, they
should be viewed in perspective. For one thing, productivity
are extremely volatile over periods as short as a few quarters,
so we shouldn't make too much of the very recent data. More
importantly, few economists expect the economy to continue to deliver
as high as 4-1/2%. Rather, there's some consensus that the
trend growth rate of U.S. productivity is probably around 2-1/2%.
is still a high number—nearly double what it had been during
the quarter century before 1995—with the potential to enhance
standards dramatically if it is maintained in the decades ahead.
Why would a slowdown from the current trend rate likely boost
In theory, slower growth in trend productivity would
have two counteracting effects. First, it likely would raise business
costs for a time,
because firms would face more rapid growth of unit labor costs.
To offset the resulting squeeze on profit margins, firms would
need to raise prices more rapidly. Eventually, increases in unit
labor costs are likely to fall back toward previous slower rates
as workers are forced to accept lower wage growth to compensate
for their slower productivity growth. But during the adjustment
period—which can last for a considerable period—there is upward
pressure on inflation.
At the same time, slower growth in trend
productivity would likely result in slower growth in aggregate
demand, which might offset
some of the upward pressure on inflation. Growth in consumer spending
would probably weaken as lower business profits limit stock market
gains, thereby reducing household wealth. More foresighted consumers
might also reduce spending, perceiving that the prospects for growth
in real wages are not as bright. Further, lower expected rates
of productivity growth should restrain business investment by reducing
the prospective return to capital.
The net impact of the two opposing
effects of productivity growth on inflation is an empirical issue.
My reading of the evidence
suggests that the predominant medium-term effect of a slowdown
in trend productivity growth would likely be higher inflation.
This makes sense to me, as it would seem to be the counterpart
to the reductions in inflation that occurred over the past decade,
when rapid productivity growth aided the Fed in bringing inflation
toward price stability.
So a key issue for inflation going forward
is whether the trend growth rate of productivity will remain near
its estimated rate
of around 2-1/2%. If so, core inflation seems likely to remain
stable, near its current moderate pace. If productivity accelerates
or decelerates, we could see inflation start to fall or rise relative
to the 1-1/2 to 2% rate that prevails today. My own view is that
the risks surrounding the outlook for productivity are roughly
Prospects for productivity
To explain why I hold this view, let me start with a brief look
at the sources of productivity growth since the surge began in
the mid-1990s. There are three basic factors to consider. First
is capital deepening—in particular, the pace at which the quantity
of capital per worker rises over time. Second is improved labor
quality, or human capital—that is, a better educated or more skilled
workforce. Third is "multifactor productivity," or MFP,
which essentially stands for all the gains in productivity that
are not accounted for by either capital deepening or improved labor
quality. It captures, more or less, the productivity gains that
ultimately stem from innovation. For example, it would include
not only the engineering and scientific knowledge that goes into
new technology, but also improved management processes, such as "just-in-time" inventory
management, as well as "creative destruction," whereby
innovative firms expand market share at the expense of less innovative
Oliner and Sichel (unpublished updates of 2002) analyzed
U.S. productivity, looking at the period from 1996 to 2001, when
to nearly 2-1/2% a year, as well as the period from 2002 to 2004,
when labor productivity rose at an annual rate of almost 4-1/4%.
They found that the initial mid-1990s acceleration in labor productivity
reflected in about equal parts an increased contribution of capital
deepening and an increase in MFP, with little, if any, change in
the contribution from worker skill improvements. But the results
for the period from 2002 to 2004 were noticeably different. This
period, of course, was the worst of the "investment bust," when
business investment actually receded. The study's results suggest
that, over those years, a further acceleration in MFP accounted
for more than all of the acceleration in labor productivity.
recent studies suggest that the explanation of the strength of
MFP growth lies in information technology (IT), where the pace
of technological innovation is clearly quite rapid. But IT's role
in the last few years appears to be different from its role in
the late 1990s. In that period, studies tend to find that MFP gains
in the production of IT contributed substantially to the overall
pickup (e.g., Jorgenson and Stiroh 2000 and Oliner and Sichel 2000;
but see also Basu et al. 2001). In addition, firms invested heavily
in new (and steadily cheaper) IT, boosting capital deepening in
industries that used IT intensively.
But for the more recent period,
studies tend to find that the MFP acceleration is more broad-based
across industries that use technology—not
confined to the IT-producing sector (e.g., Oliner and Sichel, updates
of 2002 and Jorgenson et al., 2004). Sectors that produce IT, especially
semiconductors, have actually contributed somewhat less to MFP
growth in the 2000s relative to the late 1990s.
A mechanism that
may explain the continued rise in MFP in sectors that use IT is
that firms are learning new and better ways to use
the technology they already have in place to become more productive.
Indeed, some evidence suggests that the extraordinarily high rates
of investment in high-tech equipment during the second half of
the 1990s actually reduced measured productivity growth over that
period (Basu et al. 2001). The reason is that firms had to divert
resources from current production and use them instead for installing
the new capital and learning how to use it. If firms continue to
increase their proficiency in using the technology they already
have, this could help keep productivity growing at a robust pace.
a fundamental way that IT enhances productivity is by allowing
firms to reorganize workplace operations, a process that
takes time. For example, consider Wal-Mart and other "big-box" stores,
whose new approaches to workplace organization have dramatically
affected retail and wholesale productivity. According to Sam Walton,
he benefited in the 1980s and 1990s from knowledge he gained in
the 1960s and 1970s, when he flew around the country visiting competing
discount stores and attending IBM conferences (Walton and Huey
Formal studies (e.g., Brynjolfsson and Hitt 2000, David and
Wright 2004, Bresnahan and Trajtenberg 1995, and Helpman and Trajtenberg
1998) that look at IT as a "general purpose technology"—that
is, one with broad applicability across the economy—also suggest
that it can take time to reap the benefits of technology, since
firms have to make substantial complementary investments in learning,
reorganization, and the like. For example, Brynjolfsson and Hitt
(2003) look at a sample of 527 large U.S. firms from 1987 to 1994.
They find that the benefits of computers for output and productivity
rise over time and can take at least five to seven years to be
fully realized. Basu et al. (2003) find that industries with faster
growth of IT capital in the 1980s or early 1990s had faster MFP
growth rates in the late 1990s, suggesting that firms in those
industries were undertaking unobserved investments in organizational
capital, which then paid off after a long lag in terms of measured
productivity. More generally, innovations in IT appear to have
led to co-invention and co-investment in other sectors, such as
Other studies in this literature find additional
reasons for a lag between the acquisition of new technology and
the payoff in
terms of output and productivity. For example, the benefits of
IT used by one firm, such as successful new managerial ideas, are
often adapted and adopted by other firms, a process that takes
time (for a discussion, see, for example, Bresnahan, undated).
For the latter firms, it may be easier and cheaper to innovate
by watching what other firms are doing, rather than inventing some
new organizational change themselves, because they learn by analyzing
the experimentation, the successes and, importantly, the mistakes
These analyses make me fairly optimistic about productivity
growth going forward. It seems unlikely that the business learning
reorganization that we hear about and that the academic literature
emphasizes has suddenly disappeared. My sense is that businesses
are still learning what new technologies can do for them.
We know that with the federal funds rate at 2-1/2%—only
about 1% or a bit less above the inflation rate—the current policy
remains accommodative. Over time, the degree of accommodation will
have to diminish, with policy reverting toward so-called "neutral" for
inflation to remain well contained. It's uncertain exactly what
the neutral range is, but a common estimate is 3-5%. The FOMC has
stated for some time that, with underlying inflation remaining
low, policy accommodation can be removed at a pace that is likely
to be measured. In fact, the Committee raised the rate by 25 basis
points at each of the last six meetings. However, it should be
obvious that the closer the actual rate gets to the neutral range,
the more carefully the Committee will need to consider each successive
increase. In other words, the pace of removing policy accommodation
must, in reality, depend on how economic activity and inflation
actually develop. Moreover, these developments themselves could
affect the Committee's judgment concerning the momentum in aggregate
demand or supply and thus the real federal funds rate corresponding
to a neutral policy stance.
If the pace of economic activity accelerates
and labor market slack erodes more quickly than expected—or
if some of the upside risks
to inflation materialize—it would probably be appropriate to
remove accommodation more rapidly. If, alternatively, the expansion
or we experience some of the downside inflation risks, there
are likely to be more opportunities for the Committee to pause.
course, the Committee could be confronted with more difficult
choices if output growth and inflation moved in opposite directions.
any event, risks to both growth and inflation abound. However,
I agree with the Committee's judgment, reiterated in its February
2 statement, that the upside and downside risks are currently
Janet L. Yellen
President and Chief Executive Officer
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