Robust, dynamic markets are the lifeblood of market economies. They are the source of rising productivity and, as such, of increasing standards of living. But the dynamic functioning of markets also means that productivity advances will not necessarily occur smoothly--and, indeed, are likely to involve some cyclical overshooting and undershooting, often exacerbated by waves of optimism and pessimism that seem to be inherent in human nature. Innovation by its nature is risky; some innovations work better than others, and, thus, some new ideas and the businesses that invest in or use them must be allowed to fail.

In the 1970s and early 1980s, the wage-price spiral was spun from the pass-through of rising food and energy prices to inflation, which was in turn passed along to wages and, then again, through to final goods prices. Fueling the movement were expectations that monetary policy would allow inflation to continue to rise for the foreseeable future.

I see little reason to believe that we have entered, or are about to enter, such a period of stagflation. For one thing, although current data on growth and inflation have departed from desirable levels, matters looked far worse 30 years ago than they do now.

For another, there is no evidence that wages have started to spiral up, as broad measures of compensation have expanded quite moderately over the past year. Moreover, productivity growth has been fairly robust, and, after incorporating its effects, unit labor costs were up by only ¼ of 1 percent over the past year. In addition, the slack in labor and product markets stemming from the weakening in economic activity that seems likely should put somewhat greater downward pressure on inflation going forward. Therefore, my forecast of the most likely outcome over the next couple of years is that total and core inflation will moderate from present levels.

Productivity is the fundamental determinant of growth in the longer run—it determines how we can turn labor and capital inputs into the goods and services we consume and invest. The good news here is that, while it is not as robust as it was in the late 1990s and early this decade, the underlying trend in productivity in the U.S. economy is still solid. This trend provides a sound base for production and income generation to move forward over the longer haul.

[O]ur baseline forecast sees soft economic activity this fall; notably, it is likely that a further sharp decline in residential investment will weigh on the top-line growth numbers. But we see growth recovering next year and moving up to average close to potential later in 2008, which we at the Chicago Fed currently see as being somewhat above 2-1/2 percent. This lower potential number in part reflects an assumed trend in productivity growth that is slower than the trend we experienced over the 1995-2003 period. Nonetheless, the new productivity trend is still a healthy one by longer-term historical standards and, accordingly, should support income creation, job growth, and household and business spending. Solid demand for our exports should also be a plus for growth. Although we expect a small increase in the unemployment rate, labor markets in general should remain healthy. Indeed, on balance, I would characterize the data we have received on the real economy since the last FOMC meeting as supporting our baseline forecast.

The sustainable or long-run trend growth rate of the economy is an important benchmark in calibrating the stance of monetary policy. In general, economies that grow faster exhibit real, or inflation-adjusted, interest rates that are somewhat higher than those of slow-growing economies. Monetary policymakers must be cognizant of that fact in setting the target for the fed funds rate. Failure to do so would likely result in the creation of either too much or too little liquidity, leading to too much or too little inflation or perhaps even deflation.

The answer is that Fed Chairman Greenspan guessed correctly that something unusual was going on with productivity. For example, he was hearing from businesspeople that new information technologies were transforming their businesses, making it easier for them to raise productivity. He was also a big fan of the historical work by Paul David (1990), which suggested that new technological innovations often took years to produce accelerations in productivity in the overall economy (Meyer, 2004). Chairman Greenspan was led to the conclusion that the trend in productivity growth was accelerating, a conclusion that the Board staff's forecast did not come to fully accept until late 1999 (Svensson and Tetlow, 2005). Moreover, he appeared to be convinced that the acceleration in productivity would cap inflationary pressures, implying that inflation would not accelerate even with rapid economic growth. His view prevailed in the FOMC (Meyer, 2004).

From 2000-2005, U.S. trend productivity growth is estimated to have accelerated again, as I mentioned, to around 3 percent. But productivity growth in the tech industry itself slowed down, and so did investment in tech equipment by firms that use it. Why, then, did productivity growth surge in this period, and what does the answer imply for productivity going forward? Here the stories are not so clear. One explanation begins with the notion that investment itself is disruptive, since firms have to divert resources to installing and learning to use the new capital...

Another explanation for the productivity surge in 2000-2005 is that it reflected severe profit pressures that forced firms to cut costs by restructuring, engaging in mergers, and so on.  Insofar as this explanation is at work, the cost-cutting resulted in one-time productivity gains and has not sown the seeds for faster productivity growth going forward.

Both explanations, then, are consistent with the possibility that trend productivity growth has slowed. However, I don’t want to overstate the degree of any possible slowing. We are still talking about trend growth going from about 3 percent in 2000 to 2005—the figure I cited earlier—to between 2 and 2½ percent now. So, productivity growth still would be reasonably strong, just not as strong as over the prior decade. As I said, a lower trend rate of productivity growth would help explain the sluggishness in business investment and put upward pressure on inflation for a time.

Over the last year, however, productivity growth has slowed. If this were the start of a longer-term trend, it would have important implications for the outlook for both growth and inflation. So this development deserves careful monitoring. But our take is that most of the recent slowing is likely a relatively transitory cyclical development. Firms may be finding that some of the very rapid productivity increases they experienced in the earlier years of this decade were simply unsustainable. Output may have been increased at the expense of activities such as maintenance that can be put off for only so long. In addition, given the current difficulty in recruiting qualified workers, firms may be reluctant to significantly slow their pace of hiring, even in the face of somewhat softer demand. Such "labor hoarding" is often a feature of mature expansions. We expect these developments to run their course over the next few quarters.

The competition fostered by trade should also promote productivity growth, reducing growth in costs and making the attainment of low inflation easier. That productivity growth is linked to the intensity of competition is plausible, and more-rapid productivity growth seems to help to explain the slowing of inflation in the United States in the mid-1990s. However, the fact that most other industrial countries did not experience the same increase in productivity growth as the United States during that period, even as they became more open to trade, suggests that the relationship between productivity and trade may be complex.

The rise in productivity growth has increased the economy’s potential output growth. At present, many economists estimate the potential growth rate at between 3 and 3.5 percent.

Let me add a footnote here regarding wage rates and the inflation outlook. Some observers have viewed robust wage growth as a cause of inflationary pressures; I do not share that view. We can have healthy wage growth without inflation as long as we see commensurate growth in labor productivity... I would note that the rate of growth of productivity shifted higher beginning in the middle of the 1990s, and while productivity is hard to forecast, I believe that reasonably strong productivity gains will continue and will warrant reasonably strong real wage gains. What would concern me – and we have not seen this as yet – would be a persistent increase in wage growth that was not matched by a commensurate increase in productivity growth. Ultimately this would result in higher inflation.

[T]he compensation figures in the national accounts are subject to significant revision, as illustrated by the release of new data this week that suggests hourly compensation rose only 4-1/2 percent, not 7 percent, over the past year. Changes such as this make real-time estimates of unit labor costs and labor’s share of total income much less useful in our analyses than studies based on revised data might suggest. Finally, the existing wage data are not well suited for measuring certain concepts important to modeling and policymaking, such as marginal labor costs. For example, hourly compensation in the national accounts includes stock options at their exercise value rather than at their value at the time of issuance.

Although productivity growth has stepped down from the scorching pace seen early in the recovery, factors remain in place for continued solid growth over the next few years. One element is capital deepening, that is, the rate at which the stock of equipment, software, and so forth is expanding relative to the number of workers, or--to put it even more simply, how fast workers are getting more of the tools they need. As I mentioned earlier, business investment spending has been strong in recent years and seems likely to remain at a high level for some time. Another element is improvements in the efficiency of how businesses do business. Here it appears that the flexibility of business processes and product, financial, and labor markets in the United States will continue to allow for the quick adoption of new technologies and the efficient reallocation of resources.

Since 1995, productivity in the United States has grown substantially faster than in other advanced industrial countries.  For example, a recent study by van Ark and Inklaar (2005) indicates that while productivity in the United States accelerated after 1995, average productivity in Europe actually decelerated--indeed, they estimate that the trend in the fifteen countries that made up the European Union before 2004 has been decelerating since the mid-1980s...

Increased trade liberalization, which lowers barriers to the international flow of goods, financial capital, and direct investment, also spurs innovation and creativity....

I draw two conclusions from this work.  First, trade liberalization appears to have made it possible for multinational firms to institute highly efficient cross-border supply chains within their firms that seem to have allowed them to boost significantly the efficiency of their worldwide operations.  Second, U.S. firms, on average, have more flexible and innovative business practices, sometimes called organizational capital, that a liberalized trade regime apparently allows them to transfer to their foreign operations.

That is, in the model, an increase in the level of productivity (reflecting, for example, some technological advance) causes businesses and financial markets to revise upward their views about the level of expected profits, and it causes households to revise upward their views about the level of permanent income.  The higher level of expected profits and returns to capital, in turn, lead to a rise in business investment.  Similarly, personal consumption expenditures are boosted in response to the rise in permanent income.  The initial increases in spending are then followed by multiplier effects.  A dynamic feedback also occurs on the supply side as the higher level of investment spending increases the capital stock (relative to the supply of worker hours), which gives a small fillip to productivity and potential output.  Ultimately, the increases in aggregate supply are matched by an equivalent increase in aggregate demand.  This is, of course, Say’s law.