What if the Fed pushes back on higher wage inflation to stop these pressures from infiltrating goods and services prices? Fed tightening might allow margins to hold up, but would likely induce higher market risk premiums and/or lead to slower growth, both of which would be damaging to markets.
There’s no easy way out of this quandary. Weak productivity growth leads to weak potential growth, which leads to weak real earnings. This makes it difficult to foresee an outcome that doesn’t produce sluggish growth. Also, in a world of soft global consumption, the strategy many countries are pursuing — exporting their way to greatness — is simply not viable.
Is the situation hopeless? No, there are several scenarios that could help lessen the pain:
• There could be an unexpected turnaround in productivity. It‘s difficult to see where it might come from, but this series is overdue, even if it turns out to be short-lived.
• Policymakers may accept a period of higher inflation. Coupled with excess global liquidity and easy policy, this may bolster growth and strengthen asset markets, so long as policymakers maintain their credibility.
• Labor force growth might accelerate, either through immigration policies or from a higher participation rate.
• Policymakers may turn to fiscal policy to boost growth. This is akin to using leverage to boost GDP, which would breathe some more life into a tired recovery.
Each of these developments is worth watching, although none appear very likely.
Few desirable outcomes
Full employment will place the burden on productivity growth — a weight the U.S. economy may be unable to lift. In Europe, where unemployment hovers near 10%, there is ample room to grow in the face of weak productivity. More workers will be hired but without the accompanying inflationary pressures. A likely outcome would appear to be growth convergence between the U.S. and other advanced economies, but at a slower rate of growth. This may help non-U.S. markets on a relative basis and restrain strength in the U.S. dollar.
The policy response function in this environment is uncertain. How much will the Fed be willing to accommodate an uptick in wage inflation? A larger share of labor relative to GDP, after all, is a welcome development, so long as these trends produce weaker margins rather than higher goods inflation. In many ways, policymakers are flying blind. We expect policy uncertainty to lead to higher volatility.
Collapsing productivity is one reason behind the rise in populist politics. For 10 years, relatively few have reaped the rewards of the recovery. Standards of living have fallen for most workers and exasperation is growing. These developments are also a recipe for potentially higher volatility.
If the Fed remains dovish, bonds, commodities and real assets could benefit. Loose monetary policy by other global economies might allow emerging markets to claw their way back and outpace the lackluster returns of other asset classes. If the Fed chooses to tighten monetary policy, it will likely exacerbate economic fears and restrain hiring plans and real wages. This would hinder consumption and likely lead to losses across risk assets.
Bottom line: Weak productivity growth has reached a critical level. In its early stages, weak productivity is deflationary, as seen in soft real wages, the Chinese slowdown and collapsing energy prices. As these effects fade and the employment picture tightens, the accommodative policy we have grown accustomed to will become more threatening. Easy money and a productive workforce allow us to produce more goods. Easy money coupled with an unproductive workforce produces slow growth and higher inflation, something markets are ill-prepared for. It’s time to pay attention.
John Cielinski is global head of fixed income at Columbia Threadneedle Investments.