Fed Officials Weigh the Effects
Of Slower Productivity Growth

Impact on Inflation Rate
And Interest-Rate Policy
To Be Put Under Scrutiny

By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
January 20, 2005

(See Corrections & Amplifications item below⁰.)

Almost a decade after Federal Reserve Chairman Alan Greenspan identified higher productivity as the key to inflation-free economic expansion, Fed officials see productivity growth slowing down -- and are studying how that may affect inflation and how fast they should raise interest rates.

At the moment, officials believe the productivity slowdown isn't dramatic enough to push inflation above its recent, moderate trend. The Labor Department said yesterday that inflation, excluding food and energy, was 2.2% in the 12 months that ended in December. That pace was unchanged from November but up sharply from a low of 1.1% in January 2004. (Full report¹)

"Inflationary pressures remained largely in check in December and early January," concluded a roundup of business conditions in the Fed's 12 districts, released yesterday.

That suggests the Fed, for now, is likely to continue raising its short-term interest-rate target, currently 2.25%, by a quarter percentage point at each meeting. It meets next Feb. 1 and Feb. 2.

But Fed officials are scrutinizing a recent deceleration in productivity growth, largely because its acceleration in prior years has been such a powerful damper on inflation. Fed governor Ben Bernanke said yesterday that he thinks productivity is likely to grow between 2% and 2.5% in the long run but that if it unexpectedly falls below that in the next few years, and the economy doesn't weaken at the same time, that "would likely [result in] higher inflation," and call for steeper increases in rates. If productivity growth accelerates instead, the Fed could adopt a looser monetary policy, he told the Council on Foreign Relations in New York.

Productivity refers to how much output a worker produces in an hour and helps to determine Americans' standard of living. Productivity growth also determines the economy's "speed limit," that is, how fast it can grow without putting upward pressure on inflation.

The faster productivity grows, the less costly it is for a company to produce a unit of output and the less pressure it has to raise prices. Conversely, a slowdown in productivity growth makes additional production costlier, prompting firms to raise prices to maintain profit margins.

Productivity growth averaged 1.5% a year from 1973 to 1995. Then, in a development Mr. Greenspan early on attributed to companies' ability to tap into high technology, it steadily accelerated, averaging 2.6% a year from 1995 to 2000. That enabled the economy to grow and the unemployment rate to drop sharply without the Fed's having to raise interest rates drastically out of fear of inflation.

From 2001 to 2003, productivity growth accelerated even further, to 4.2%. That meant that even though wages and benefits were rising between 3% and 4% a year, labor costs, adjusted for rising output per worker, were actually declining. That spectacular productivity performance led to the "jobless recovery," because firms were able to meet rising sales without more workers.

More important to the Fed, productivity growth has served as a powerful buffer against inflation; indeed, by driving labor costs down, it contributed to the Fed's deflation worries in 2003. As long as productivity remained strong, the Fed worried less about higher commodity prices and numerous other factors that normally would unsettle it.

But in the past six months, that buffer has started to shrink. Productivity growth slowed sharply to an annual rate of about 2% in the second half of last year, near the bottom of the 2% to 3% annual rate that many at the Fed believe it should achieve over the long haul. Unit labor costs are now rising. This leaves the Fed much less margin for error on inflation.

What is behind the slowdown? Mr. Greenspan said last year that the corporate technology-spending spree of the 1990s created a "backlog of unexploited capabilities for enhancing productivity," and that companies turned to this backlog when the economy turned down in 2001, in search of ways to cuts costs and avoid adding workers. The productivity slowdown in recent months might mean that companies have used up much of that backlog and will have to invest more to boost future productivity.

There appears little sign the Fed, or Mr. Greenspan, have lost their long-term optimism on the productivity potential of new technology. A continuation of strong productivity growth would be good for higher profits and wages, and even alleviate Social Security's long-term funding shortfall. A survey of purchasing managers conducted at Mr. Greenspan's request has found, year after year, that most feel they have exploited only half the potential of new technology. "Estimates of structural productivity growth remain high, although there has been some moderation recently," Tim Geithner, president of the Federal Reserve Bank of New York, said yesterday in a speech to the Business Council of Fairfield County, Conn.

Others are less sure. In a speech last year, Fed Vice Chairman Roger Ferguson cited signs that the pace of innovation is slowing: The price of computing power is not falling as rapidly as it once did and fewer new personal-computer models are being introduced. Even if the long-run trend for productivity growth remains bright, Fed officials are watching to see whether temporary factors pull it below that long-term trend for the next year or so, creating inflation risks.

Write to Greg Ip at greg.ip@wsj.com²

Corrections & Amplifications:

Federal Reserve governor Ben Bernanke spoke in New York Wednesday before the Council on Foreign Relations. An article on productivity Thursday incorrectly said he spoke in Washington.

Japan Risks Recession
With Tax Increases

By SEBASTIAN MOFFETT
Staff Reporter of THE WALL STREET JOURNAL
January 17, 2005; Page A2

TOKYO -- Eight years ago when the Japanese government raised taxes, the move was blamed for killing the economic recovery. Now that taxes are heading higher again, some economists here are bracing for a possible return trip to recession.

The government hasn't quantified the size of the tax increase, but economists have their own estimates. A combination of new pension and social-security payments plus tax increases will mean an extra burden of about 7.2 trillion yen, or about $70.5 billion, over three years, starting this year, according to Jesper Koll, Merrill Lynch & Co.'s chief economist for Japan. He calculates that will slice about 2% off the total disposable income of the Japanese.

That isn't as big as the 1997 tax increase, which pushed the consumption-tax rate to 5% from 3% and along with other increases added about nine trillion yen to the nation's tax bill. Some consumers were so angry at the higher consumption tax that they staged demonstrations. Others simply closed their purses, a factor that helped to capsize economic growth.

While economists worry that history is about to repeat itself, government officials say the country's huge debts leave it little choice. Japan has by far the worst government-debt problem in the industrialized world. Debt outstanding now amounts to 169% of gross domestic product, and has risen every year since 1991, when it was 65%, according to the Organization for Economic Cooperation and Development. That compares with 65% of GDP for the U.S. now and a 78% average for the euro area, both lower than a decade ago.

Japan's problem resulted from ballooning public spending and falling tax revenues, as the government tried to stimulate the economy out of its 1990s doldrums. Japan now has a primary deficit -- the gap between tax collections and the national budget -- of 7% of GDP.

The new tax increases are the government's attempt to get a grip on the problem. A series of complex pension and social-security contribution increases have begun this year. Heavier tax increases are expected to pass Japan's parliament in the next few weeks. This legislation will abolish part of a 1999 special income-tax reduction starting in 2006, which economists say will mean 180,000 yen, or about $1,800, more to pay for a four-person household with an income of 10 million yen, or about $98,000. A similar measure is planned on top of that for 2007.

These moves concern economists, who say the tax increases will discourage consumers from shopping, at a time when Japan really needs them to keep spending to boost growth. The economy is going through a slow patch now, remaining essentially flat during the most recent two quarters. If exports, Japan's main engine of growth, fail to pick up, badly timed tax increases could tip the economy into recession. "It's a tax-increase marathon," Mr. Koll says. "You're putting on the brakes when you're slowing down anyway."

So why can't Japan just erase its government debt with faster growth? After all, the U.S. escaped big budget deficits in the 1990s with relatively small tax increases, as fast growth fueled higher tax revenues.

But Japan is unlikely to get out of its debt bind so easily. For a start, its problem is much worse than that faced by the U.S. Japan's ratio of debt outstanding to GDP is already more than twice that of the U.S. at its 1993 peak, which was 75%. In addition to the primary deficit, Japan also has to pay interest on the money it is already borrowing. So, in spite of the tax increases, Japan's ratio will continue climbing to about 175% by the end of 2006, forecasts Brian Coulton, a senior director of Fitch Ratings' sovereign group.

Japan also can't expect economic growth that's powerful enough to wipe away its deficits. Prime Minister Junichiro Koizumi has been cutting spending since he took office in 2001, but the main cause of Japan's budget deficits is falling tax revenue. Tax revenue peaked in 1990 at 60.1 trillion yen, and plunged to 41.7 trillion yen in 2004.

"High growth like in America might solve this, but you can't expect that," says Mamoru Yamazaki, an economist in the Barclays Capital Tokyo office.

Ministry of Finance officials say Japanese taxes are low by international standards and can be higher. The country's "national public burden," the sum of taxation plus social-security payments, is about 35%, almost the same as in the U.S., which has a lower proportion of retired people. The burdens in the United Kingdom and Germany are more than 50%, and are still higher in some other European countries. "Why should Japan be only 35%, when its society is so old and is growing older still?" said Koji Yano, an official in the Ministry of Finance's tax office, at a seminar last year.

Trying not to trip up the economy as happened in 1997, the government this time is attempting a stealthier approach to tax increases. The forthcoming round is being phased in over several years, and isn't expected to have the shock value of the 1997 consumption-tax rise.

If the economy returns to healthy expansion during the next few quarters, it likely will survive the tax increases, economists say. But if Japan continues to flirt with recession, the new taxes could make the economy contract. However, the Ministry of Finance and leading politicians plan even more tax increases for the future. In particular, an increase in the consumption tax is likely around 2007. "If you think about the economy, tax rises are bad," says Barclays economist Mr. Yamazaki. "But this will be the case anytime, and you can't leave the situation like it is."