Information overload is a pitfall of the digital era we live in. A ton of apparent topics get covered in mainstream financial media. The interesting bit is to explore and educate on lesser discussed issues.
Alan Greenspan, the 13th Chair of the Federal Reserve, served five terms from 1987 to 2006. He is best known for having presided over the “Great Moderation”, a period from the mid 1980s to the GFC of 2007, characterized by relatively stable inflation and solid economic growth. The term “Greenspan Put” a cornerstone at the intersection of monetary policy and financial markets is another of his legacies. Also, one of his key achievements, is said to be the “Soft Landing” navigated in the US economy in the mid 1990s.
Have a look at the charts below.
The first chart show US labour productivity through the 1990s. The second shows US labour productivity from right before the pandemic till date. The question to ask ourselves is will the productivity boom experienced by the US economy from mid 1995 till the end of that decade (marked in red) repeat itself in the next few years to come?
Why does that matter? Read on..
US Labour Productivity 1991 to 2000
US Labour Productivity 2019 to Q3 2023
The monetary policy tightening cycle of 1994-95 is remembered as probably the only instance in recent history when the Fed achieved a soft landing. After a brief recession (caused by the Gulf war), the US economy witnessed 2-3 years of stellar GDP growth in the early nineties.
GDP Growth up until the monetary tightening cycle of 1994
Inflation concerns from a booming economy led to Greenspan initiating 7 back-to-back rate hikes starting from February 1994.
Rate Hikes starting 1994
The last of these rate hikes took place in February 1995. By the first quarter of 1995 there was some slowdown in economic growth, but far from unequivocal clear signals of a significantly slowing economy or rapid disinflationary indicators. Yet, Greenspan initiated a series of rate cuts. Starting from July 1995, the Fed cut rates 3 times by a cumulative 75 basis points into the start of 1996.
Rate cuts starting mid 1995
Up until May 1995 inflation was still running at a solid 3.0%. The US economy continued to record robust growth. Yet Greenspan saw what no one else did. The upcoming productivity expansion.
Relationship between Productivity, Inflation and Wages:
Now, let me shift gears a bit and explain the relationship between Productivity, Inflation and Nominal wage gains. Wage growth can be said to equal productivity growth plus inflation. All other things being equal, if productivity grows at 1.5% and nominal wages grow at 4.5%, that can likely mean an average realized inflation of around 3%. Explained in another way, productivity improvements lead to a higher output for the same hours of labour worked. Higher output per hour of labour gives companies and businesses the ability to raise wages without crimping profit margins or eroding competitiveness. This fuels a virtuous cycle of economic growth and wage gains. But the low unit labour costs on the back of continuous productivity gain keep inflationary pressures low. This is precisely what occurred in the late nineties.
Labour productivity improved substantially as foreseen by Greenspan..
Wages gained through the period…
And yet inflation remained fairly benign through most of the late nineties…
The productivity change of approximately 2.1% was significantly greater than the 1.4% and 1.6% seen in the previous two cycles of the seventies and the eighties.
The productivity boom and economic growth also translated commensurately into company earnings and consequently equity market performance. (Needless to say there were a ton of other factors which influenced that period’s equity performance including the famous “irrational exuberance” of the late nineties)
Does History Rhyme?
There has been ample amount of literature that attempts to explain the post 1995 productivity acceleration. Some of the key points to note are –
- Investments in Information Technology caused an increase in labour productivity throughout the economy. The semi-conductor industry experienced rapid innovation with better performing chips and shorter gestation periods for node innovation. The emergence of the internet further contributed to a demand boom for personal computers
- High or increasing competitive intensity resulted in the spread of innovation. For instance, in general merchandise retailing, Walmart’s success forced competitors to improve operations. Pharmaceutical wholesalers responded to competition from large retailers by automating distribution centers.
- Another key aspect of the post 1995 productivity boom was that the US experienced a much larger increase in productivity compared to the rest of the world.
- Low inflation itself created competitive pressures which forced businesses to spur productivity growth (although there is a circularity in this argument)
While the intent of the note is not to dive into the absolute specifics of the post 1995 productivity spike, it would be remiss to not draw some parallels to the current trends in the world. While AI might be an over-hyped and often abused term, it hard to miss daily narratives of simple improvements to personal and corporate lives – ranging from work from home to virtual meetings to digital assistants to electric vehicles to driverless cars to lightning speed 5G connections to gene editing to tele-medicine to 3D printing. The list is almost endless.
Summary:
So what’s the summary? The BLS released US labour productivity data on 2nd Nov 2023. The report showed non-farm business sector labour productivity increased a substantial 4.7% in the 3rd quarter of 2023. Productivity has been improving since Q3 2022. If we continue to see an above trend improvement in productivity, wage increases at 4.0 – 4.5% can be sustained without causing a wage price spiral. The almost elusive “Soft Landing” will have actually materialized then! There are a ton of other factors to consider including the role of relative leverage in the economy, which is significantly higher now compared to the late nineties and can potentially have devastating effects on the economy and risk assets. Similarly, it is also key to consider fiscal dominance given budget deficits of 6-8%. Nonetheless, it is equally key to keep an eye on productivity trends. Like the cliché says, history does not repeat itself but it often rhymes.
Not meant to be Investment Advice. Do your own research. Happy investing!
Shashank Sawant
