Economic Impact: Worker Productivity Growth Might Influence Fed’s Interest Rate Policy

Taking a look at worker productivity growth could shed some light on what the Federal Reserve might do with interest rates.

The faster the rate of productivity growth, the faster the Fed can let the economy grow without inflation picking up.

But productivity is slow right now compared to historical benchmarks.

By definition, growth in productivity means the same amount of output can be produced with fewer hours, which sometimes translates into fewer workers. Over the long run, this often means the workers who remain in the industry are paid more.

Productivity growth leads to rising living standards.

Yet, it also is a double-edged sword as workers who lose their jobs due to productivity improvements need to find employment elsewhere.

Productivity growth also is an important contributor to how fast the overall economy can grow. It is an important driver of what the Federal Reserve has referred to as the maximum sustainable growth rate or potential growth rate of real gross domestic product.

Productivity in manufacturing grew 2.4 percent in the fourth quarter of 2014 compared with the same quarter in the previous year while mining industries productivity grew 3.9 percent in 2014, according to the U.S. Bureau of Labor Statistics.

About 75 percent of manufacturing and mining industries posted gains in 2014 compared with about 60 percent in 2013.

Productivity grew the fastest in 2014 in oil and gas extraction category followed by textile and fabric finishing and coating mills.

The potential growth rate varies over time and is dependent on productivity and labor force expansion.

A simple way to estimate the potential growth rate is to add the annual productivity growth rate, which was 0.9 percent from 2008 through 2014, with the labor force growth rate of 0.5 percent during that same period.

As a result, the potential growth rate of real gross domestic product was 1.4 percent during that period.

That is much slower than the 3.3 percent average potential GDP growth rate from 1950 through 2014.

During that time, productivity averaged a faster 1.8 percent a year and the labor force grew an average annual 1.5 percent.

Looking ahead, the Congressional Budget Office is estimating productivity to grow 1.6 percent and the labor force to advance 0.5 percent a year from 2015 through 2025.

That would equate to a potential growth rate of 2.1 percent a year.

In other words, growth in living standards could be much slower over the next decade than it was over the last half century.

In addition to predicting changes in living standards, the difference between the potential growth rate and projected GDP growth is considered by the Federal Reserve when it decides whether to try to speed up or slow down economic growth to meet its long-term goals.

The Federal Reserve tends to increase the overnight interest rate that banks charge each other, known as the Federal Funds Rate target, when the economy is consistently growing faster than it potentially should and to lower this rate when the economy is growing too slow.

Despite an anemic 0.2% real GDP growth in the first quarter of 2015, many economists are looking for about 3 percent GDP growth in the second half of 2015 and in 2016, which provides another reason why the Federal Reserve will likely be increasing the federal funds rate target later this year.