Output and jobs pose statistical mismatch
By Krishna Guha
Copyright The Financial Times Limited 2007
Published: April 26 2007 19:34 | Last updated: April 26 2007 19:34
If you believe the official statistics, something very strange is happening in the US economy. Output growth is bouncing along at about 2 per cent – below almost every economist’s estimate of US potential growth – but unemployment is not going up. In fact unemployment ticked down in March to 4.4 per cent.
This is odd, since one of the oldest rules of economics, Okun’s law, implies that, when output grows by less than its potential growth rate, unemployment should go up (to be precise, it should rise relative to the natural unemployment rate).
There are essentially three possible explanations for the output/unemployment mismatch. The first is that the official statistics are understating the true unemployment rate – perhaps because of difficulties tracking the employment status of illegal migrant workers.
This is possible, though the unemployment rate is based on a household survey that should catch all types of worker.
The second is that the official statistics are underestimating the true growth rate of the economy. Economists normally cite gross domestic product – an output-based measure – as the most reliable measure of economic activity.
However, there is another estimate of economic activity called gross domestic income – an income-based measure.
In principle, after all appropriate revisions, the two should add up to the same thing. In practice the two series often diverge.
Over 2006 as a whole, and also in the second half of the year, GDI rose more rapidly than GDP. This may indicate that the GDP series is understating growth, possibly because of difficulty capturing small businesses and start-ups in service sectors.
If GDP is later revised up, it would result in better productivity figures for recent months.
However, if both the unemployment and output statistics are correct, only one possible explanation remains: US potential growth has fallen sharply, at least in the very short term.
First quarter GDP figures to be published on Friday are likely to show productivity growth close to zero year-on-year . The question is whether this decline is essentially cyclical – due to labour hoarding as the economy slows – or in part at least the result of a decline in the trend productivity growth rate, which would help determine the potential growth rate of the economy going forward.
When the economy first dipped below trend in mid-2006, the cyclical explanation looked the most plausible. As every month passes, though, it becomes harder to argue that it is simply a result of time lags before companies ditch surplus workers.
This might still be the case. Construction firms are still holding on to a surprisingly large number of workers, given the collapse in new home sales. This is holding down the overall unemployment rate and also depressing economy-wide productivity measures.
Peter Hooper, chief economist at Deutsche Bank Securities, says falls in construction employment tend to lag behind falls in total construction activity by two quarters – or six months. He says it is “still too soon” therefore to dismiss the notion that the weakness in productivity is essentially cyclical and will be short-lived.
On the other hand, surprisingly weak business investment could be signalling that companies in a wide range of sectors outside construction do not see opportunities to make productivity-enhancing investments.
There is always the possibility that they could be incorrect about the scope for such investments. But even if they turned out to be wrong, sustained underspending on capital goods could result in a lower speed limit for the economy in the medium term (in the long run, technology wins out).
Most Federal Reserve policymakers have already revised down their base case estimate of potential growth from 3-3.25 per cent a year or two ago to 2.75-3 per cent today. They may need to incorporate into their thinking some risk that potential growth could in fact be still slower – perhaps 2.5 per cent or even less.
What a lower rate of growth of productivity, and therefore of potential output, would mean for interest rates is less obvious than it might seem at first glance.
As Ben Bernanke has said in speeches both as a governor and as Fed chairman, the immediate implications of a step-change in productivity growth on rates depend on the extent to which consumers and businesspeople factor it into their calculations.
In the late 1990s productivity rose, but businesses and consumers quickly factored all or more of the benefit into their near-term spending decisions, putting upward pressure on inflation.
In the early 2000s productivity rose again, but businesses and consumers were slower to factor it into their spending activity, putting downward pressure on inflation.
If the trend rate of productivity growth has now fallen significantly, the Fed rate response will depend on whether consumers and businesspeople figure this out and alter their spending behaviour, or continue to base today’s spending decisions on over-optimistic expectations of the future.