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US productivity slump another reason for Fed to keep rates low

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An unexpected drop in productivity may confirm the Federal Reserve's worst fears of a US economy slipping into an extended period of slow growth with little it can do about it.

[SAN FRANCISCO] An unexpected drop in productivity may confirm the Federal Reserve's worst fears of a US economy slipping into an extended period of slow growth with little it can do about it.

Hourly output per worker dropped an annualised 0.5 per cent in the April-June period, US government data Tuesday showed, a third consecutive quarterly drop that puts the economy on track for its longest productivity slump since the era of stagflation, when a weak economy and high inflation coincided with four straight quarters of dropping output per worker.

Growth in average hourly output per worker was below one per cent from 1979 to 1983, as the Fed waged a battle against rampant inflation with crippling interest rates that triggered a recession and rising unemployment.

The latest productivity figures pull the current average down even lower, to just 0.5 per cent a year over the past five years, much lower than the 1.5 per cent or so growth that many Fed officials have been banking on.

Moreover, labour cost growth today is a fraction of what it was in the stagflation era. So if the current trend remains - and nothing in recent Fed commentary suggests policymakers believe they expect otherwise - it means the central bank has yet another strong reason not to raise interest rates.

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"These downward revisions should leave Fed officials even more confident that the upward pressure on domestic prices remains muted," said Paul Ashworth, an economist at Capital Economics.

"That is another reason to believe the Fed will delay the next interest rate hike until December."

The productivity slump has been weighing heavily on leading minds at the Fed, where the work of Northwestern University economist Bob Gordon has a growing following, based on, among other measures, the number of times his work is cited by top Fed officials in speeches.

In a recent interview, Mr Gordon, who believes productivity trends are driven by factors such as the aging of the US population and will not be easily shifted by the introduction of new technological innovations, said the decline poses "a constraint on their ability to manage the economy."

"The numbers are just too stark to ignore," he added.

Productivity is tied closely to the economy's potential trend growth, to the ability to generate better wages and rising living standards, and to the pace of job creation and inflation.

Slowing productivity growth is one reason that Fed officials have ratcheted down their forecasts for economic growth, and now estimate sustainable long-run growth at about 2 per cent annually.

Barclays economists on Tuesday said the latest data suggest even those downgraded forecasts may prove too optimistic.

One silver lining is that lower productivity growth means firms may need to hire more since each worker produces less - as long as demand for goods and services remains strong.

The downside: it can be inflationary, though recent data has presented a muddled picture of whether unit labour costs are rising faster or not. So far, inflation overall has been tame, running well below the Fed's 2 per cent target.

Low rates may yet prove helpful in boosting investment, research spending, and new firm start ups, all factors that should on the margins feed into higher productivity, Fed Chair Janet Yellen has said.

But in the longer run, productivity growth is an issue that is largely beyond the Fed's control, tied rather to things like the economy's pace of innovation, investment in basic research, and improvements in the overall level of education.

"Smarter and better trained people are the foundation of future productivity growth," said Mr Gordon.

Without improvement in that growth, he said, "Every aspect of the standard of living is affected."


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