“Productivity Eases Powell’s Pain-Free Disinflation” By Reuters

By Howard Schneider

WASHINGTON (Reuters) – A noticeable increase in U.S. productivity has highlighted Federal Reserve Chair Jerome Powell’s developing narrative regarding the potential for inflation to decrease even amid ongoing job and economic growth.

The ideal scenario would depend on the U.S. achieving a new equilibrium between the demand and supply of goods and services, not by “destroying” demand through conventional Fed interest rate hikes, but rather through advancements in the economy’s capacity.

Recently, there has been an unexpected positive turn, evidenced by more individuals entering the workforce, including new immigrants, and a rise in individual worker productivity. This trend effectively lowers labor costs, even with increasing wages.

Data released recently revealed that productivity surged by an impressive 4.7% in the third quarter, marking the largest increase in three years and the second significant gain within this year. Consequently, unit labor costs decreased at an annualized rate of 0.8%.

This development results in greater potential output with reduced inflationary risk, something Powell emphasized during a recent discussion, where he expressed optimism that the economy currently possesses enhanced capabilities for growth, job creation, and wage increases without triggering inflation.

The upcoming employment report will provide updated labor force estimates, a crucial piece of the economic puzzle. After stagnating for much of 2022, the workforce increased by 3 million workers, or around 2%, during the first nine months of this year.

This situation is a key reason why the Fed maintained its policy interest rate at 5.25%-5.50% during its recent meeting, despite recent data indicating that the economy expanded at a remarkable annualized rate of 4.9% in the third quarter, well above the 1.8% rate that Fed officials consider the long-term, noninflationary trend.

Throughout the pandemic, growth has frequently surpassed this rate, even as inflation has continued to decline. Powell addressed this conundrum at his post-meeting press conference, indicating that while long-term trend growth is believed to be slightly under 2%, the potential for growth in the near term is currently elevated due to improvements in labor supply.

Higher potential growth provides the economy with more capacity to expand without raising inflation concerns, creating a greater opportunity for the central bank’s desired “soft landing” scenario, where inflation decreases while the economy remains on a stable trajectory.

Rising productivity suggests a decrease in inflationary pressures even as the economy shows significant resilience. According to an economist, if companies can achieve strong productivity growth, they may be less inclined to pass increased input costs onto consumers.

The Fed’s current position bears similarities to the mid-1990s when then-chair Alan Greenspan resisted pressures to raise interest rates, advocating that rising productivity would allow for economic growth with lower inflation—an insight noted for supporting strong economic performance during that decade.

Since then, productivity growth has been more subdued, with a consensus that long-term growth per worker hour hovers around 1.5%. This, along with slow population growth, has led Fed officials to reduce their estimates for long-term economic output growth, which has remained at approximately 1.8% since 2016.

Powell and his colleagues now must evaluate the sustainability of these recent improvements.

As Powell noted, there is a potential for a beneficial cycle in which ample job growth, rising wages, and ongoing economic expansion occur alongside a steady decrease in inflation, bringing price pressures back in line with target levels.

However, challenges may arise, as the sustainability of the current growth trajectory remains uncertain. If the positive trends were to end, the Fed could face tougher decisions regarding the necessary slowdowns needed on the demand side to maintain inflation within acceptable limits.

Recent analyses suggest that growth may slow in the upcoming quarter due to the impact of higher rates dampening activity in certain areas. Yet, if real growth continues robustly, disinflation is expected to progress, potentially leading to renewed inflation pressures that could compel the Fed to re-enter a tightening cycle.