American workers are becoming less productive. That’s bad news for the Fed

New York (CNN) — Federal Reserve officials are widely expected to announce on Wednesday a pause in their regimen of rate hikes.

After 10 consecutive hikes, investors are pricing in a 94% chance that the Fed will leave rates unchanged for the first time since January 2022, according to the CME’s FedWatch Tool.

But a pause is not a full stop.

The labor market, which policymakers believe to be a key driver of inflation in the dominant services sector of the economy, is still remarkably strong. Now there’s a growing consensus on Wall Street that central bank officials could restart the hikes, meant to fight elevated inflation, as soon as July.

But what does the Fed mean when it talks about labor markets and their impact on inflation? A lot of it has to do with a troublesome slowdown in productivity.

What’s happening: At its most basic level, labor productivity is a measure of the value of the goods and services produced by a company compared with the amount of labor used to produce that output.

Productivity moves in the opposite direction to wages and so if it remains depressed, there will be upward pressure on labor costs — and ultimately on inflation, said Lisa Shalett, CIO of Morgan Stanley Wealth Management.

That’s a big deal to Fed officials who have spoken publicly about their fears of a wage-price spiral — the feedback loop that drives inflation higher as people make more money and go out and spend it.

“The crosscurrents for the Fed are complex. Big bets about the pace of the hiking path are ill advised,” said Shalett.

During the Fed policy meeting in May, participants expressed worry that even though the pace of wage growth has been gradually slowing, it’s still “running at a pace that, given current estimates of trend productivity growth, was well above what would be consistent over the longer run with the Committee’s 2% inflation objective,” according to minutes from the meeting.

Productivity in the United States has been steadily declining since 2005, but the post-pandemic landscape has accelerated that downturn significantly. Labor productivity decreased 2.1% in the first quarter of 2023, the US Bureau of Labor Statistics reported earlier this month.

That was the worst reading since 2007, according to the BLS.

Bad for the economy: A lack of qualified labor is one of the biggest challenges for companies today, according to a new McKinsey Global Institute report. Returning to the 2.2% average annual growth in productivity seen between 1948 and 2019 (compared to 1.4% between 2005 and 2019) would add $10 trillion to US GDP — or about $15,000 per household by 2030, the report found.

In comments late last year, Federal Reserve Governor Lisa Cook told a crowd in Michigan that “innovation and productivity growth undergird our long-term growth prospects.”

Over the long run, labor productivity “means everything” to the economy, said Joseph Brusuelas, chief economist of RSM US.

The silver lining: The good news is technological innovations typically drive upturns in productivity and AI could be such an innovation. Still, those benefits could take some time to materialize, warned Bank of America analysts on Tuesday.

EOs, leaders have mixed feelings about AI

Artificial intelligence has been billed as the technology that will revolutionize the world as we know it. Google CEO Sundar Pichai has even called it “more profound than fire or electricity or anything that we’ve done in the past.”

But some executives aren’t convinced.

At an online meeting Monday of more than 250 leaders convened by Jeffrey Sonnenfeld, head of the Yale School of Management’s CEO Leadership Institute, there was little agreement about how to handle AI.

About 42% of leaders on the call said that AI could have catastrophic implications while 58% said no, according to Chief Executive, an independent CEO news and data group that attended the debate. About 87% of the CEOs at the event said they disagreed that AI’s potential was “overstated,” but there were still some key divergences, the group reported.

Connecticut Democrat Senator Richard Blumenthal, who was on the call, said that there needed to be “a kind of nutrition label so that people can distinguish between the faith and the true, and so that there is greater identification, watermark, if you will, on some of these products,” according to Chief Executive. “There’s a lot of government support for some kind of government regulation,” he said.

Walmart (WMT) CEO Doug McMillon, said that “it’s a really exciting time” for AI and that “it feels like frequently that we’re only limited by our imaginations as it relates to what we can do.”

Technology investor Roger McNamee added that he fears the cost of maintaining large AI systems are going to explode in the current high interest rate environment, and that those costs could soon be passed down to customers.

Director Steven Spielberg, who was being honored on the call, had the last word. AI is okay, so long as it doesn’t interfere with his work, he said: “As Vito Corleone said in the first Godfather movie, ‘as long as your business doesn’t interfere with mine.’”

Yellen on US-China trade: ‘Decoupling would be a big mistake’

Janet Yellen said Tuesday that it’s best if the United States retains ties with China, even as tensions between the two nations grow.

“While we surely have concerns that need to be addressed, decoupling would be a big mistake,” Yellen said in her testimony before the House Financial Services Committee on Tuesday. Americans “benefit greatly” from buying goods that are cheaper to produce in China, she added. China equally benefits from US exports that also bolster the US economy.

That’s why, she stressed, it would be “disastrous” to cease trading with China, reports my colleague Elisabeth Buchwald. “De-risk? Yes. Decouple? Absolutely not,” Yellen said, echoing the joint statement leaders from the Group of Seven made at last month’s summit in Japan.

Yellen also called on lawmakers to lend more money to developing countries to counter China’s growing influence.

In addition to increasing lending to International Monetary Fund programs, Yellen told lawmakers that the Biden administration wants to boost involvement in the Inter-American Development Bank group’s private-sector investment fund and the African Development Fund.

“These investments will bolster our engagement in these regions at a time of geopolitical competition,” Yellen said. Lending to organizations like the IMF “serves as an important counterweight to nontransparent, unsustainable lending from others like China.”

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