When Federal Reserve policymakers gather this week for their final meeting of the year, the focus will be on an expected quarter-point rate cut and policymakers’ latest outlook on the economy and the prospects for rate cuts.

But shaping those discussions and the longer-term path of monetary policy is an emerging debate about productivity and how fast output can grow in order to stay within the economy’s capacity and keep inflation from rising above the Fed’s 2% target.

The annual growth rate of output per hour of U.S. workers is known to fluctuate widely in the short term, but the long-term trend appears to be stable. Since 2019, the annual growth rate of output per hour of U.S. workers has climbed from about 1.5% in the previous decade to an average of about 1.8%, and has been even higher recently.

Over time, even small improvements can become significant, and this boost occurs in the early stages of the spread of AI tools, which may enhance this improvement.

Its implications could be profound, affecting everything from the trajectory of federal debt to the impact of upcoming Trump administration policies. For example, in an environment of rising productivity, the impact of labor shortages caused by immigration crackdowns may be easier to absorb. Elected Vice President JD Vance seemed to foresee this when he spoke last summer to the New York Times about McDonald's workers being replaced by kiosks and moving on to higher-paying jobs.

U.S. productivity growth may exceed long-term trends

The growth in U.S. productivity shows enough persistence that confidence in a U.S. productivity model slipping into a 'low growth' state has shifted from nearly 100% to below 60%.

'It's still too early to say whether there is a real transformation, but it certainly seems more likely,' said James Kahn, an economics professor at Yeshiva University and former vice president of research at the New York Fed.

There is 'reason for cautious optimism,' wrote John Fernald, an economics professor at INSEAD, in a recent report from the San Francisco Fed, where he previously served as an economist. This is one of the more influential voices in the Fed recognizing the limited but important issues of productivity, and Fernald is skeptical that U.S. productivity growth will exceed long-term trends.

Federal Reserve officials are increasingly aware of this possibility, which may affect policymakers' thinking about economic potential. In the years leading up to the COVID-19 pandemic in 2019, the Fed's estimates of the sustainable long-term growth rate for the U.S. had been steadily revised downwards, partly due to lagging productivity.

In reality, economic growth often exceeds the Fed's own estimates of potential, and this has continued even as inflation has eased in the past two years. The growth in productivity plays a role, and if recent trends continue, the Fed may need to reconsider the direction of the economy and the potential inflation associated with any growth rate, which may also lead to higher estimates of the long-term 'neutral' interest rate that the U.S. market can bear.

U.S. GDP actual growth surpasses potential growth

Productivity issues are critical for the Fed

According to the minutes of the Fed's meeting from November 6 to 7, a reassessment is underway, with staff raising their internal estimates of economic potential, and policymakers are debating whether recent trends will continue.

'I can't tell you how difficult it is to get productivity to exceed its long-term trend,' said Federal Reserve Governor Cook last month.

Cook's economic research mainly focuses on innovation, and she noted that this shift (the growth in productivity) has significant statistical and economic implications in recent years.

Like other Fed officials, Cook cited several possible reasons: more effective job matching, persistently high levels of business activity during the COVID-19 pandemic, and investments in artificial intelligence that may maintain this trend.

Chicago Fed President Goolsbee stated earlier this month, 'We need to start taking seriously the idea that this situation is ongoing' and clarify the policy implications.

'Some business people say... they're having a hard time hiring, so they've invested in machines. The reason they are using labor-saving technologies is precisely because they can't find people,' Goolsbee said. 'I do think there is some field evidence.'

In economics, productivity is a kind of panacea; considering the need for increased investment and innovation, it is not entirely a free lunch, but it allows workers to produce more with less time or fewer resources, thus enabling wages and profits to rise without triggering inflation.

Improving productivity has been one of the ways to control unit labor costs and align with the Fed's inflation targets, even as wage growth has consistently exceeded the levels policymakers consider non-inflationary.

Productivity growth offsets wage growth

This is one reason why the Fed is still willing to continue cutting rates even when economic growth is still above trend levels and the unemployment rate is at a reasonable level.

The question now is whether it can be sustained and for how long.

Earlier this month, Federal Reserve Governor Quigley stated that recent strong productivity is 'very important' for the economy and the central bank, but warned that upcoming changes in global tariffs and trade policies could pose risks.

'The incoming administration and Congress have yet to enact any policy, so it's still too early to make judgments,' Quigley said. However, 'once the specifics come out, it will be important to study them, as trade policy may affect productivity and prices.'

Article forwarded from: Jin Shi Data