Productivity could surprise markets, giving the economic recovery and equity rally room to run
The recent bout of market volatility demonstrates just how alert investors are to the risks posed by higher inflation. As former Federal Reserve chair Janet Yellen so eloquently put it: “recoveries do not die of old age”.
Instead, they tend to be killed off by central banks when rising inflation signals an economy is trying to grow too quickly for its resources – the labour, physical capital and natural resources it has available.
With the US recovery in its 10th year and unemployment now at multi-decade lows in many of the world’s largest developed economies, it is clear there is not an abundance of available workers to facilitate growth. It is sensible to question whether workers will start asking for higher pay.
Should workers’ demands increase, this would put an end to the Goldilocks scenario of strong growth and moderate inflation that markets have enjoyed so heartily for the past few years. Many analysts are thus focused single-mindedly on when inflation will return.
But there is another route from here receiving much less attention: one in which productivity rises. While it is true companies will find it more difficult to expand their workforce in places such as the US, UK and Germany, they might be able to squeeze a bit more output from each existing member of staff.
Such an increase in productivity seems to have been written off by most forecasters and one perhaps can’t blame them for this. Growth in output per worker has been woeful for more than a decade.
A plausible explanation for such a dismal performance is surely that, following the worst recession in decades, firms favoured expansion with labour rather than capital. That approach minimised upfront costs and maximised flexibility in case activity slowed once more.
Firms are certainly now feeling better about the future. Investments in plant and machinery are on the rise, for example. Last year was not only the strongest pace of business investment growth in the G7, it was also the first year expansion was synchronised across all seven countries. As workers are better equipped with new capital, productivity should recover.
Such a productivity recovery would sit comfortably alongside the advances we are seeing in new technology.
The impact of these new technologies can take some time but then be felt suddenly. In 1996, then-Fed chair Alan Greenspan raised a pertinent question: “With all the technological advancements of the past couple of decades, why has our recent productivity data failed to register any improvement?” Three years later, productivity was running at 3.5 per cent and it appeared, for a while at least, as if the US economy could grow at 4 per cent forever.
I am certainly not suggesting we are about to see productivity growth surge to the levels seen in the tech boom. But for growth to sustain the pace seen in 2017 without inflationary consequences, it does not need to. A far more modest pickup will suffice.
With the US, UK, Germany and Japan close to full employment, we are at a fork in the road.
One fork sees rising inflation as the economy begins to exert too much pressure on the natural capacity of its resources. In such a scenario, central banks would have to deviate from their current plans of a very gradual and predictable normalisation of monetary policy. In other words, they would have to return to the monetary brake rather than merely ease off the accelerator. The economy and markets would suffer.
The other fork that warrants at least as much attention is a productivity rebound.
Firms squeeze more out of their workforce and in turn pay them a bit more without unit labour costs picking up, because for that bit of extra pay they are getting more output to sell.
If the recovery continues and inflation stays benign, central banks can normalise policies slowly in the background without detriment to either growth or markets.
Remember that, through the second half of the 1990s productivity boom, the Fed held its policy rate at close to 5 per cent – what was considered neutral at the time. Over that time, the US economy expanded by a third in nominal terms and the S&P 500 returned 230 per cent.
While the downside risks from inflation are real, they are also well known. We are comforted by the fact far less attention is paid to the upside risk of productivity. It might well be productivity that surprises markets, giving the economic recovery and the equity rally room to run.
Karen Ward is chief market strategist for the UK and Europe at JPMorgan Asset Management