With the gulf crippled by Hurricane Katrina -- and now threatened anew by Rita -- it's no wonder that Wall Street is obsessing over how hurricane season will affect the economy and monetary policy. The havoc wrought by Katrina crimped economic growth by throwing millions of people out of jobs and destroying billions of dollars' worth of homes and other physical capital. It also pushed up inflation by sending energy prices skyrocketing.
While Federal Reserve policymakers too have been wrestling over the effects of Katrina, they've also been debating a more fundamental question that will affect the economy long after the hurricane's impact is gone: Is the underlying growth rate of productivity slowing? Some believe it has and point to sluggish business investment in efficiency-enhancing computers and other equipment to buttress their claim. Others are more upbeat and see scant sign of a slowdown.
The resolution of the debate has big implications for the economy and for Fed policy. Fading productivity growth lowers the "speed limit" for the economy -- the rate at which it can grow on a sustained basis without sparking faster inflation. If underlying productivity growth really is slowing, that means that the Fed may have to follow up its Sept. 20 quarter-point rise in interest rates with a few more rate hikes if it wants to keep price pressures in check.
Productivity growth has slowed sharply over the past few years, dropping from a year-over-year rate of 5% in the fourth quarter of 2003 to 2.2% in the second quarter of this year. But such fluctuations are normal responses to the cyclical ebbs and flows of the economy. More important is the underlying rate of long-term productivity growth -- what economists call the sustainable rate. But that's devilishly difficult to discern through the gyrations of the economy.
Fed Chairman Alan Greenspan was among the first to recognize in the mid-1990s that productivity growth was picking up on a long-term basis, despite widespread skepticism inside and outside the Fed. But recently, he's sounded a bit more cautious about how long the productivity revolution can last.
What has prompted some Fed officials to begin rethinking productivity are revised economic data for 2002-2004. The figures show that economic growth over that period was slightly slower than first estimated. But just as important, they also showed that capital investment in both 2003 and 2004 was a lot lower than initially thought. The revisions have prompted some top Fed officials -- most prominently, San Francisco Fed President Janet L. Yellen -- to mark down their estimates of trend productivity growth.
What's more, business spending so far this year hasn't picked up as strongly as some Fed officials hoped. Excluding defense and aircraft, capital goods shipments have fallen in five of the first seven months of this year, according to the latest data from the government.
The steep rise in energy costs -- and the likelihood that they'll stay high for a while -- also threatens to undermine productivity growth by making existing factories less efficient, some Fed officials believe. In certain cases, such as in the chemical industry, companies have been forced to shut down plants because it's become too costly to run them.
In other cases, they've diverted money that would have been spent on improving worker efficiency and instead used it to cut down on energy usage. While that reduces their costs, it does little to boost output. Dow Chemical Co, for instance, is pouring money into its effort to reduce its energy consumption. "We are constantly looking for projects," says Gordon E. Slack, business director of Dow Chemical's energy business. "The problem of high energy prices is not a short-term one."
As execs across industries hatch similar plans, productivity gains could suffer. Some Fed officials now peg the underlying rate of productivity growth at about 2 1/4% vs. the 2 1/2% or more they thought previously. That would put the economy's speed limit at something closer to 3%, rather than 3 1/2%.
But not all economists are convinced productivity growth is slowing on a sustained basis. Some minimize the importance of outlays on technology, noting productivity growth held up through the tech spending bust at the start of this decade.
They argue it's not technology spending alone that determines worker efficiency. It's how the workers make use of the equipment they're given. "While tech plays an important role in productivity growth, it's really the business process changes that drive it," says Martin N. Baily, who served as White House chief economist under President Bill Clinton. Baily, now with the Institute for International Economics think tank in Washington, pegs the trend growth of productivity at 2 3/4% to 3%.
CURB ON INFLATION
Competitive pressures also play a key role in promoting productivity growth, according to this school of thought. An upcoming study on the automobile industry from consultants McKinsey & Co. makes just that point, noting it was competition from Japanese transplants that finally forced Detroit to improve efficiency. And such pressures are not about to go away anytime soon in an increasingly globalized economy.
As Greenspan and his colleagues have sought to manage the economy's vicissitudes over the past decade, they've been greatly aided by the strength of productivity. It allowed the economy to grow faster without pushing up inflation. Now, as the 79-year-old chairman prepares to step down early next year, some at the Federal Reserve are wondering whether the central bank's luck has run out. If so, the economy could face tougher times ahead.
By Rich Miller in Washington, with Michael Arndt in Chicago