November 1999
Federal Reserve Bank of Dallas

Productivity, the Stock Market and Monetary Policy in the New Economy

One of the defining features of the new economy is faster productivity growth. One of the new economy's most prominent—and, to many, most worrisome—features has been a booming stock market. Of the new economy's implications, those for monetary policy are among the most controversial.

This presentation discusses productivity growth—what it is, why it's important, and evidence that it has recently been increasing. It also touches on the stock market and what it's saying about expectations for future growth in productivity. However, the bulk of the presentation is devoted to an analysis of the connection between productivity growth and monetary policy. The main point is that, for policymakers, whether productivity growth is high or low is less important than whether productivity growth is rising or falling. Rising productivity growth means good times for central bankers. It means the Federal Reserve can realistically hope to deliver low unemployment, rising wages, more rapid output growth, and—at the same time—falling inflation. Once productivity growth stabilizes—even if at a high level—policy choices become more difficult.

The good news is that we're experiencing faster productivity growth and that there are reasons to believe this faster growth will continue. Over time, even a small increase in productivity growth can lead to a huge increase in living standards for Americans. President McTeer was among the first to recognize that a new productivity trend is emerging.

But every silver lining has its cloud. Although productivity can keep rising forever, productivity growth can not. Hence, we must be prepared for a shift to a less favorable policy environment. Looking ahead, the days of low unemployment and falling inflation are numbered, even if the days of rapid output growth and high stock prices are not.

For policymakers, the big challenge will be recognizing this shift when it occurs.

Productivity Growth

What It Is. When people talk about "productivity," what they usually have in mind is "labor productivity"—output per hour or output per worker. Government statisticians distinguish between three underlying sources of labor productivity growth.

The first is increases in the amount of plant and equipment per worker. For example, I've recently had a ink-jet printer installed in my office. It saves me from having to walk down the hall when I print something from my computer. It saves others on the floor from having to wait for my documents to print. So, both my productivity and that of my colleagues has increased.

The second source of productivity growth is improvements in the quality of the work force. On average, one would expect a work force with more schooling and more job experience to be more productive.

The final source of productivity growth is improvements in technology and the organization of the production process. In other words, better equipment and better management. The short-hand label economists apply to productivity gains from this third source is "multifactor productivity growth."

Why We Care. Productivity growth is important because it is the main determinant of changes in our standard of living. Figure 1 shows the growth rate of GDP per capita along with the growth rate of labor productivity. Note how growth in GDP per capita tends to rise and fall along with growth in labor productivity.

The most striking feature of the figure is the big slowdown in both productivity and per capita GDP growth it shows during the 1970s. Annualized per capita GDP growth fell from 2.5 percent in the 1950s and 1960s to 1.1 percent in the late 1970s as productivity growth slowed from 2.4 percent to 0.5 percent per year. We don't yet have a good understanding of the causes of this deterioration.

Although we saw a partial reversal in the 1980s and early 1990s, it's only been during the post-1995 period that labor productivity and per-capita GDP growth have fully recovered. Driven by rapid productivity increases in the high-tech industries, over-all productivity growth is back to where it was during its post–World War II "golden age."

The timing of the increase in productivity growth is noteworthy. Ordinarily, productivity growth surges as we emerge from a recession, only to taper off as the economic expansion matures. In contrast, the recent increase began after the economy had already been growing for nearly five years. So, there's reason to believe that the increase is not just a "flash in the pan."

So much for the sources of productivity growth and the connection between changes in productivity and changes in our standard of living. What connection is there, if any, between productivity growth and the stock market?

Irrationally Exuberant?

Productivity and the Stock Market. The fact that the period since 1995 has been marked by sharp increases in price/earnings and price/dividend ratios is suggestive of a connection between productivity growth and the stock market (Figure 2). A connection makes intuitive sense, too. For a given rate of labor force growth, the more rapid is growth in productivity, the greater are the potential growth rates of output, earnings, and dividends. With faster expected growth in earnings and dividends, people are willing to pay more for a stock at any given level of current earnings or current dividends. That's why an Amazon.com can be worth many times more than a Barnes & Noble, despite having current operating earnings that are only one-sixth as large.

Of course, interest rates, inflation, and uncertainty affect stock valuations, too. However, holding all these other things constant, high stock-market valuations ought to signal that investors expect rapid productivity growth.
Figure 3 shows what happens when you use price/earnings and price/dividend ratios to predict future productivity growth, after controlling for changes in other variables. (In the figure, actual productivity growth in the non-farm business sector is shown as a yellow line and investors' productivity expectations, formed four quarters earlier, are shown as a light blue line.) The chart says that prior to the 1987 crash and again as the U.S. entered the 1990 recession, actual productivity growth fell short of what investors had been counting on. In retrospect, stocks were overvalued. Similarly, shares were undervalued in late 1995, and overvalued in late 1996 and early 1997. Subsequent growth in productivity has pretty well matched expected growth. In other words, the high and rising stock market valuations we have seen recently have—so far—been justified by high and rising productivity growth.

As of last quarter, investors were anticipating an additional 70-basis-point rise in productivity growth during the coming year. Are these expectations realistic? If you don't think so, maybe it's time to sell.

Summary. What have we learned so far? First, productivity growth appears to have doubled from a little over 1 percent to about 2.5 percent per year, at a point in the business cycle when growth would ordinarily have been expected to slow. Second, the high stock prices we have seen lately suggest that investors are expecting continued rapid productivity advances. Indeed, current market valuations are difficult to justify unless productivity growth increases even more.

That productivity growth is high and may well remain so is extraordinarily good news: it's the story that belongs on the front page with the banner headline. But for those of us involved with making monetary policy, there are some more obscure details of the story that are important, too.

Productivity Growth and Monetary Policy

Is Inflation Dead? Since the fourth quarter of 1995, inflation has trended downward even as output has accelerated and unemployment has fallen to a 30-year low (Figure 4). This performance has led some commentators to proclaim that inflation is dead. Is it true that in the new economy, with faster productivity growth, the Fed need no longer worry about inflation? To see, one must look at the linkages between wages, prices, productivity, and unemployment.

Figure 5 traces the relationship between changes in wage growth and the level of unemployment over the period from 1959 through 1995. Note that wage growth tends to rise over time when the unemployment rate is low, and to fall over time when the unemployment rate is high. The critical unemployment rate is about 5.5 percent. Recent experience has been generally consistent with this historical relationship. Since 1995, tight labor markets have been accompanied by ever higher rates of wage increase. To quote Alan Greenspan, "If the pool of job seekers shrinks sufficiently, upward pressure on wage costs is inevitable, short of a repeal of the law of supply and demand."

We've just seen that money wage growth rises or falls depending on the amount of slack in the labor market. Figure 6 shows that real, or inflation-adjusted, wage growth closely tracks growth in labor productivity. Faster productivity growth means faster real wage growth. In particular, the higher rates of productivity growth that we've seen since 1995 have been accompanied by correspondingly more rapid real wage growth. The linkage isn't perfect, but it's pretty good. The linkage also makes sense: firms ought to be willing to pay their workers more, in real terms, the more productive they are.

Why has inflation been falling, despite tight labor markets? The key to the mystery is rising productivity growth. As shown in Figure 6, real wage growth—the difference between money wage growth and inflation—is closely tied to growth in labor productivity:

Wage Growth – Price Growth = Productivity Growth

Turning this relationship around, price growth is linked to growth in unit labor costs—the difference between wage growth and productivity growth:

Hence, if productivity growth is rising quickly enough, inflation can fall even if tight labor markets are driving wage growth higher. In other words, rising productivity growth can offset, or more than offset, the inflationary effects of tight labor markets. That's exactly what we've seen over the past three and one-half years. Good times for Joe Six Pack and good times for central bankers: more rapid growth in output and wages, a falling unemployment rate, and declining inflation. All made possible courtesy of the high-tech productivity revolution.

However, if it is rising productivity growth that has kept tight labor markets from putting upward pressure on inflation, then policymakers have reason to be wary. For productivity growth, even if it remains high forever, cannot keep rising forever. Once productivity growth stabilizes, the buffer between labor markets and inflation will disappear. Inflation isn't dead, merely sleeping—awaiting the day when productivity growth begins to level off.

Tough Policy Choices Ahead. It is useful to run through a couple of examples that illustrate how the policy environment will change when productivity growth stops rising. In each case, I assume that the economy enjoys a five-year period during which productivity growth rises from 1.25 percent per year to 3.5 percent per year (Figure 7). The 1.25 percent figure approximates the trend rate of productivity growth in the U.S. economy in the early 1990s. As noted above, the 3.5 percent figure matches the rate of productivity growth that stock market investors expect during the year 2000.

Of course, it may be that real-world productivity growth will move even higher than 3.5 percent. But it can't keep rising forever, and these illustrations assume that 3.5 percent is the limit. Each year from 2000 on, the average worker produces 3.5 percent more output than he did the previous year. That means a 3.5 percent pay increase, above inflation, each year for the average American—up from 1.25 percent per year back in 1995. There's no question that society in general is much better off because of this transition to a higher rate of productivity growth. People feel a whole lot wealthier than they did before—and justifiably so.

During the five-year period of rising productivity growth, life is pretty rosy for Fed policymakers, too. They can simultaneously deliver low unemployment and falling inflation.

Figure 8 shows a path for the unemployment rate that approximates the actual path seen in the United States over this period. It also shows predicted paths for output growth, wage growth, and inflation that are implied by historical relationships, given the assumed changes in productivity and unemployment. Note that wage growth is predicted to rise by over one percentage point over five years. Inflation falls by almost the same amount. Output growth rises from 2.25 percent in 1995 to 4.7 percent in 1999, to just over 5 percent in the year 2000. On the whole, the predicted patterns of output growth, wage growth, and inflation pretty well approximate what we've observed in the U.S. economy over this period.

The exercise shown in Figure 8 makes the Fed's job look a lot simpler than it actually was. Productivity-growth and inflation trends that are obvious now weren't at all obvious at the time. Many economists were afraid that falling unemployment and rapid output growth would lead to higher inflation, and wanted a tighter monetary policy. At the other extreme were analysts concerned that, without a looser policy, we might actually see falling prices—like those which contributed to the Great Depression. Fortunately, "new-paradigm optimists" like Mr. McTeer and Alan Greenspan won the day.

Policy making in the years ahead—as productivity growth stabilizes—is going to be even more difficult. I'll look at two extreme policy choices. The first assumes that the Fed tries to hold the unemployment rate at 4 percent. Results—shown in Figure 9—are as follows. First, because the unemployment rate remains low, labor markets stay tight and wage inflation rises indefinitely. Second, because rising productivity growth no longer acts as a buffer between wages and prices, price inflation reverses direction and begins to follow wage inflation upward. Finally, because the unemployment rate is no longer falling, output growth slows—but only a little. A policy that implies ever-increasing inflation is ultimately unsustainable: holding the unemployment rate down permanently is not really an option. The real message here is that the longer you try to keep the unemployment rate down, once productivity growth has leveled off, the higher the inflation rate you're going to be saddled with. Fortunately, the acceleration in prices is initially fairly gradual, giving policymakers some leeway.

At the opposite extreme from a policy that tries to hold down the unemployment rate is a policy that holds down the inflation rate. The consequences that pursuing a hard-line anti-inflation stance would have for the labor market and output growth are displayed in Figure 10. Note that, because wages and prices respond with a lag to changes in productivity growth, holding inflation down requires only a gradual return of the unemployment rate to its original level. Rising unemployment—combined with low inflation and steady productivity growth—is sufficient to halt the acceleration of money wages. Rising unemployment also means sluggish output growth—a "growth recession." The figure suggests that this growth recession would be more prolonged than deep.

In summary, the days of low unemployment accompanied by falling inflation will be over once productivity growth begins to level off. If we try to hold the unemployment rate down after this date, we can expect wage pressures to begin spilling over to prices.

Know When to Hold Them, Know When to Fold Them. How will policymakers know when it's time to shift gears? The conventional wisdom is that low unemployment, rising wage growth, rapid output growth, and high stock valuations are all symptoms of an overheated economy. When we see several of these at once—as we do today—it's a clear signal that we need tighter monetary policy.

The conventional wisdom is at best a half-truth. The fact is, low unemployment and accelerating wages are perfectly consistent with a declining inflation rate if productivity growth is rising. Similarly, unusually rapid output growth and historically high stock market valuations may simply signal that productivity growth is at a higher level now than in the past. If so, they are to be celebrated, not feared.

The implication is that the conventional inflation indicators are of little use unless you know what's happening to productivity growth. Unfortunately, available measures of productivity growth bounce around a lot from quarter to quarter and are subject to major revisions. So, timely recognition of productivity trends is impossible.

It follows that the best place to look for emerging inflation pressures is probably in the inflation statistics themselves. That doesn't necessarily mean waiting for consumer price inflation to start rising. Changes in commodity prices often give advance warning that retail-price increases are "in the pipeline."

Conclusions
The good news is that productivity growth has sped up. That means more rapid gains in living standards for the average American and higher real wages for workers.

Investors are counting on continued solid growth in productivity. Indeed, they are betting that productivity growth will increase further in the year ahead. In the past, investors have had a pretty good record of anticipating productivity trends.

The bad news, from the perspective of the Federal Reserve, is that even if productivity growth remains rapid, policy making is likely to become more difficult. The tension between our desire to maintain low rates of unemployment and our desire to maintain a low rate of inflation will increase in the years ahead.

—Evan F. Koenig

About In Depth This article is based on a presentation by Evan F. Koenig, senior economist and assistant vice president, Research Department, Federal Reserve Bank of Dallas. The views expressed are those of the authors and do not necessarily reflect the positions of the Federal Reserve Bank of Dallas or the Federal Reserve System.