Productivity continues to rise in potential game changer for economy

REAL ECONOMY BLOG | February 01, 2024

Authored by RSM US LLP

Paul Krugman, the Nobel laureate in economics, once said that “productivity is not everything, but in the long run it’s almost everything.”

The increase in American productivity over the past year, if sustained, is a potential game changer for the economy that represents that mythical rising tide that lifts the living standards of all.

The 3.2 % increase in productivity during the final quarter of the year and 2.7% on a year-ago basis has most likely been a catalyst for both robust economic growth and disinflation over the past year.

To put this in perspective, productivity has averaged a 1.5% increase over the past decade, which partly explains the less-than-satisfying increases in the standard of living across the economy despite impressive technological breakthroughs.

While it is difficult to ascertain whether the gains since the pandemic are the result of a fundamental shift in the economy or a one-time jump in overall output per hour per worker, the strong increase is surely welcome news, especially as the Federal Reserve lays the groundwork for its pivot to a lower-rate environment.

Normally, when demand runs hot, pressures on prices increase, but that was not the case last year.

Rarely have we seen significant growth and disinflation taking place at the same time. So while we are encouraged, we still need to understand better what caused the recent spike in productivity, in particular over the past six months.

The economy overall continues to show resilience. In the third and fourth quarters last year, gross domestic product grew by 4.9% and 3.3% respectively; inflation has declined to 2% on a six-month annualized pace, according to the Fed’s key inflation metric, the personal consumption expenditures price index; and the unemployment rate stands at 3.7%.

That strength was due, in part, to rising productivity that helped create the conditions in which the economy could grow faster even at full employment while inflation growth eased at the same time. One might even state that is what is causing the soft landing of the economy following the inflation and interest rate shocks that started in 2021.

Rising productivity is a classic economic win-win that that benefits each participant. And of course, rising productivity helps the Federal Reserve as it seeks to fulfill its dual mandate of achieving price stability and maximum sustainable employment.

In our estimation, the policy tailwind that is releasing a significant quantity of capital into the economy is helping to promote this more efficient and highly productive economy.

Investment spending on structures grew at a torrid pace of 8% in each quarter on average over the past six months, while spending on intellectual property and equipment grew by 5.5% and 2.8% on average, respectively.

But we think there’s more to the story about what’s driving the surge in productivity:

An increase in labor through higher wages that attracted disaffected and discouraged workers back into the labor force.

An economy at full employment, which permitted workers to acquire better jobs and receive training thus increasing output per hour.

An increase in supply of manufacturing capacity through the CHIPS and Science Act, the bipartisan infrastructure act, and the Inflation Reduction Act, which is part of an increase in the supply of energy through alternatives.

An increase in supply of labor through legal immigration.

It is no mystery that during a time of high inflation, high borrowing costs and persistent labor challenges, businesses were forced to become more efficient by making productivity-enhancing investments.

Inside our RSM US Middle Market Business Index survey, we have consistently observed since the pandemic a sustained increase in actual and planned outlays on capital expenditures. Those investments are now paying dividends across the economy.

With recession risks fading, businesses have signaled a more aggressive stance when it comes to investment plans, according to the latest results from our survey. Nearly half, or 46%, of senior executives at middle market businesses said they had increased spending on capital expenditures and 66% said they expected to do so in the first six months this year.

But it is too soon to claim that there is a permanent structural change in productivity as the choices of investments become more selective amid high borrowing costs.

Research around some of the popular explanations for a structural shift in the labor market, like work-from-home or investments in artificial intelligence, remains inconclusive. We do not expect the impact of artificial intelligence investments to show up materially for another three to five years.

Still, the short-term productivity gains because of upgraded equipment, factories and technologies in the past two years will help the economy to continue to run strong instead of running hot this year.

And that is the recipe for that mythical tide that lifts all boats and with it the economic fortunes of all Americans no matter where they exist on the income ladder.