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posted on 30 March 2016

Market Reflections: What Is The Real Drag On Economic Growth?

by Gene D. Balas

While precise forecasting is always difficult, certain trends may shape how the economy might unfold. Let's examine a few key drivers of particular interest in today's environment: productivity gains, economic growth, inflation and the policies of central banks around the globe. (Another driver, geopolitical events, can quickly impact financial markets but since they are unpredictable, they are outside of the scope of this discussion.)

The Role of Productivity in Profits and Wages

Productivity gains have been lacking, and that is the essential ingredient for both companies to expand output from their current employees and for wages to rise more substantially than inflation. If productivity fails to accelerate, potential economic growth may be suppressed while inflation may emerge in a way that benefits neither companies nor their employees. We can examine the trend in place in recent years in the nearby graphs that look at productivity vs. corporate profits and productivity vs. wage growth.



You'll observe the productivity has allowed real (net of inflation) wages and corporate profits to grow in tandem with productivity: there is an observable correlation between these data series. Now observe the inverse correlation productivity has had with inflation: the lower the productivity gains, the higher inflation figures have tended to be.


Inflation: Linkage to Productivity

So what might be the likely direction of inflation and economic growth with productivity gains as the driver? If the economy continues to expand, even moderately, at a pace that exceeds the growth of the labor force plus productivity gains, then the supply of available (and qualified) workers will continue to diminish. With the unemployment rate currently at the economy's "natural" rate of unemployment, does that mean that slack may now be reduced to the point where wage gains may accelerate?

  • On the one hand, the real level of labor market slack may be such that there is a large supply of workers available to choose from. However, many of these individuals may have been out of work for an extended period and have seen their skills atrophy, or they may have experience in different fields than those in demand by employers. If these workers are eventually hired, their contribution to output may be less than current staff, further suppressing productivity.

  • On the other hand, wage pressures may build as employers bid higher for the most qualified talent. That could spark the wage gains the Fed would like to see. But as we have noted above, without productivity gains, inflation may consume those wage increases, limiting the benefit in the real economy.

In short, if we can't extract more output per hour from existing staff, we may see more inflation in coming periods, even as growth is expected to stay tepid.

Central Bank Policies: No Easy Choices

The Federal Reserve is in a difficult spot then. On one hand, the Fed observes that employment has trended up while the unemployment rate has steadily fallen. That points to good news on the economic front, right?

Well, consider the inverse relationship between hiring and productivity: hiring has tended to be stronger when productivity has been lower, and vice versa. Companies need to hire more workers when the output per hour worked of their existing staff doesn't allow production to increase by even moderate amounts. As such, the focus on employment gains may be missing this particular connection.


As a result, there may be more inflation around the corner - even though economic growth may continue to be only moderate, and not robust. While it may take some time to get there, that could eventually put the Fed in a difficult spot of needing to tighten rates more aggressively before the market is "ready."


Weak productivity gains may continue to cause employment to increase more than historical patterns would suggest given current economic activity. That may drive up wages - but any resultant increase in inflation could cause real wages to remain stagnant. Alternatively, should companies not be able to pass through cost increases to customers, it may dent corporate profits. In reality, it may be a little bit of both.

However, the Fed may be encouraged by rising wages. It may view that these costs would, at some point, be passed along to customers so that the Fed may hike rates as it intends. Still, the Fed may likely be cautious about raising rates too aggressively. After all, necessity is the mother of invention, and allowing more inflation from rising wage pressures may be the spark for companies to institute new technologies and processes that may finally enhance those missing productivity gains.


Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances.

The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. Indices are unmanaged, do not consider the effect of transaction costs or fees, do not represent an actual account and cannot be invested to directly. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies.

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