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Productivity Gives the Fed Wiggle Room

By Michael Wallace The theory that the late '90s spawned a durable outward shift in the productivity curve was vindicated by the resilience of output-per-hour through the recent recession. Yet one vexing byproduct of this otherwise welcome trend is the yoke it has put on employment growth as the economy struggles to get up to full steam. MMS expects that second-quarter nonfarm productivity growth will accelerate, even as employment continues to remain weak. The implication for U.S. monetary policy is that subdued inflation will allow the Fed to give growth and workers a chance with continued accommodative policy.

Following relatively subpar productivity gains of 0.7% in the fourth quarter of 2002 and 1.9% in the first quarter of 2003, MMS forecasts that productivity will rebound to a healthy 5% in the second quarter of this year, when latest numbers are released on Thursday, Aug. 7. This sizable gain should boost the productivity average back above the robust 2.5% trend established in the late '90s.

The expectation of a sizable second-quarter jump is based on assumptions of a 3.5% growth rate for output (as measured by the Bureau of Labor Standards index) combined with a likely 1.5% rate of decline in hours worked. As Corporate America has moved aggressively to attack its cost base, second-quarter unit-labor costs should drop 1.5% -- following gains of 1.5% in the first quarter and 3.2% surge in 2002's last quarter.

FEWER HOURS WORKED. On a year-over-year basis, nonfarm productivity should post a 3.4% gain in the second quarter. These boosts should make it easier for the Federal Reserve to continue fostering gross domestic product growth with extremely accommodative policy.

Further making the case for this Fed stance was additional evidence in the July employment report of a jobless recovery. Though the unemployment rate dipped from 6.4% to 6.2%, the economy shed 44,000 nonfarm payroll jobs, and figures for June were revised downward. Though 42,000 temporary hires gained employment in July, the workweek skidded to a fresh all-time low of 33.6 hours.

The Challenger Report by outplacement firm Challenger, Gray & Christmas corroborated this damp outlook with news that planned layoffs jumped more than 25,000 in July, to 85,100. One bright spot has been consecutive declines in weekly initial unemployment claims, keeping the figure below the 400,000 mark. However, this number has been plagued by some distortions, and MMS expects that the Aug. 7 report will put the weekly initial claim number back at 400,000.

LENDING TRENDS. One possible explanation for the frustrating labor lag is that it may not be exceptional in the early stages of economic recoveries, regardless of a new productivity paradigm. An economic letter by the San Francisco Fed compares the last recovery -- in the early 1990s -- to the present. Both were characterized by weak labor markets, but they are differentiated by banking-system practices. The report, entitled Bank Lending to Businesses in a Jobless Recovery, found that in a full-fledged rebound, banks are typically willing to lend more, perhaps too much, while in a recession or early stages of recovery banks usually are less willing to lend.

This has been borne out by the latest Fed Senior Loan Officer Survey, which shows that bank lending tends to rise in the good times and fall in the bad, with a commensurate impact on business spending and hiring. Hence, the Fed has felt compelled to request that banks tighten standards when growth veers out of control and relax them when credit creation would help stimulate jobs and growth.

In policy terms, a motor metaphor from Bob McTeer of the Dallas Fed drives the point home: "We may be on hold, but with the accelerator down to the floor. With productivity strengthening, the economy's speed limit is higher, and we have to run the economy hotter to generate growth that creates new jobs." Wallace is a senior investment strategist for MMS International

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