SUDDENLY these are times of high anxiety for the American economy. On Wall Street, and around the globe, observers are gripped by a gnawing angst over US prospects.
It is easy to grasp why. US growth has slowed abruptly. The world’s No 1 economy saw its annual pace of expansion drop from 5.6 per cent in the first quarter to just 2.5 per cent in the second. Yet, at the same time, inflation seems to have re-emerged with a vengeance. Even after stripping out soaring energy costs and the volatile price of food, it was running at an annual pace of nearly 3 per cent over the April to June period.
The combination of sharply weaker growth and accelerating price pressures is a nasty brew for any economy. In the US, nervousness over this unwelcome situation has been heightened by the handover at the Federal Reserve from Alan Greenspan to its new Chairman, Ben Bernanke, and uncertainty over how America’s new economic helmsman will respond.
The quandary that the unfortunate Mr Bernanke now faces amounts to the trickiest of legacies from his predecessor. It comes to a head on Tuesday, when he must decide whether or not the Fed should raise interest rates for the eighteenth time in a row. Caught between the Scylla and Charybdis of a faltering expansion and rising inflation, he will be damned if he does, and damned if he doesn’t. It is an unenviable dilemma.
What should he and the Fed do? I have argued here before that the US slowdown now taking hold, coupled with the delayed effects of the Fed’s past rate increases, should ultimately put a lid on the present outbreak of inflation. This remains the case. As Henry Paulson, the new US Treasury Secretary, implied last week, a cooling in America’s past breakneck growth is needed now, not only to cap inflation but also to pave the way for the unwinding of the other persistent imbalances in the world’s biggest economy.
Still, is seems clear now that while slower growth is necessary, it is not sufficient. US inflation is now at levels substantially in excess of those in Britain and Europe — and of what would be tolerated on this side of the Atlantic. Mr Bernanke should therefore resist the siren voices on Wall Street tempting him to peg interest rates. Instead, he should order a further increase, even one of a half-point.
As well as directly confronting the inflation risks, this would have two further desirable consequences. It would make absolutely clear the Fed’s determination not to permit inflation to become re-embedded in the American economy. It would also help to put an end to the mutterings that the Fed Chairman is an excessively doveish soft touch.
Mr Paulson’s situation looks equally uncomfortable. Pondering the situation a few weeks into the job, he must be painfully conscious already of the predicament of all holders of his office: that while often they are left to carry the can on Capitol Hill and among voters for economic difficulties, most of the power to shape events lies down the road at the Fed.
But as he no doubt realises, he can take consolation from at least one factor suggesting a much rosier medium to long-term outlook for the United States. Outperforming productivity still offers America great expectations for its economic future, as a compelling new analysis from Mr Paulson’s former employers at Goldman Sachs argues.
Growth in productivity — the amount of output generated for each hour of labour — is the life-force of a dynamic economy. It is this that determines how fast an economy can expand without stoking inflation, which promotes higher living standards and fosters enhanced profitability.
For now, US productivity growth is seeing the sort of typical dip experienced in the later stages of any business cycle. This only worsens the country’s deteriorating growth- inflation trade-off.
As Goldman’s Andrew Tilton argues, however, this is likely to prove merely a temporary pause in a US productivity boom that is “far from finished”.
Since the mid-Nineties, America has seen productivity surge ahead, rising at an average 2.9 per cent pace to record its best decade since the Sixties. As studies by experts such as Dale Jorgenson, of Harvard, show, this phenomenon has been driven by two forces. Crucially, US companies have invested heavily in high-efficiency information and communications technology (ICT), to extract more value for each hour worked. In addition, companies more recently have turned to extracting still more gains through better organisation and processes to exploit this technology. This has boosted so-called “total factor productivity”.
After a ten-year spurt, some might fret that this process may have run its course, but Mr Tilton sets out some persuasive arguments why it should persist for a lot longer. First, continuing, rapid innovation in the IT industry suggests that this part of the equation has plenty more to contribute. Indeed, many companies and sectors have still to switch to state-of-the-art technologies to enhance performance.
Secondly, economic history teaches that it takes decades for businesses to tap the full potential of big, “disruptive” technological innovations. Even while there are some companies at the forefront of seizing on new processes, laggards take many years to catch up — as data pointing to big gaps between American companies’ effective use of ICT suggest. So still more total factor productivity gains should emerge.
The conclusion of Goldman’s research, and one shared by other leading researchers, is that average, year-on-year US productivity growth in a buoyant range of 2.2 per cent to 3 per cent over a further decade looks more than feasible.
Inevitably, there are blots on this rosy landscape. Technological bottlenecks, the supply-side impact of record oil prices, or many other factors, could thwart progress.
Yet despite this, amid the sudden US gloom, there are reasons to be cheerful. Productivity prospects should offer at least a partial panacea for America’s present anxieties.
