Productivity, inflation, & geopolitics
Structural drivers of higher inflation will be offset by strengthening productivity growth, but with significant variation across economies
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Over the past several months, inflation has moderated substantially from its peaks in 2022 as some of the transitory factors fade (energy prices, global supply chain disruptions). However, the remainder of the disinflationary process is likely to be challenging, as last week’s US inflation reading reminded.
My assessment is that we are moving into a period of structurally higher inflation across advanced economies. This is due to factors such as: persistently tight labour markets, reinforced by aging populations; increased frictions in global supply chains, with an increased frequency of shocks and distortions caused by geopolitical rivalry; as well as expansionary ‘wartime’ fiscal policy, as governments increase spending/investment on defence, industrial and innovation policy, the net zero transition, and so on (see my recent note on geopolitics and macro policy).
There will be some countervailing forces. For example, there will be a deflationary impulse from Chinese over-production in sectors like EVs and renewables (as discussed in last week’s global briefing note), although this effect will be constrained by pushback from some importing countries that impose trade restrictions.
Productivity & inflation
The most powerful offset to the structural increase in inflation would be a material, sustained positive supply-side shock: a ‘productivity renaissance’ that allows stronger, non-inflationary growth to be sustained.
Labour productivity growth has been in decline across most advanced economies over the past several decades; and productivity growth flattened off again in the decade after the global financial crisis. But there is potential for productivity growth to return strongly. The pandemic was a useful forcing event in this regard.
Significant investments in business capex were made during and since the pandemic, as firms regeared their businesses for a new context (for example, digital, automation). More capital and technology-intensive production methods are likely to lead to higher productivity growth over time, particularly when coupled with a high-pressure economy. Tight labour markets, with accompanying wage pressures, will strengthen incentives for investment by firms in productivity-enhancing technologies.
This is reinforced by the policy response to strategic geopolitical rivalry. Industrial policy initiatives like the Inflation Reduction Act have led to accelerated capital investment by firms, particularly in strategic sectors such as semiconductors, as well as increased investment in research and innovation. US manufacturing construction has trebled since 2021.
There is some evidence of stronger labour productivity growth in the US, where these investment dynamics are further developed than other advanced economies. In the year to Q4, US labour productivity growth came in at 1.4% (0.8% qoq) continuing a run of strong data. Although labour productivity growth remains below long-term averages, it is well above its post-global financial crisis trend. This productivity strengthening will need to be sustained for several more quarters before it looks like a trend, but this productivity data is encouraging. And it is a positive surprise relative to forecast, suggesting that there are some new dynamics at work.
Elsewhere across advanced economies, however, there is less evidence of a productivity improvement. Labour productivity in the EU is negative (-1.0% in the year to Q3) on sluggish GDP growth and strong labour market performance, combined with relatively weak capital investment. Similarly, the UK’s labour productivity growth was close to zero in 2023. Neither the UK nor the EU have been able to move back towards the pre-pandemic trend labour productivity growth.
Labour productivity growth in small advanced economies is also generally modest, constrained by weakness in world trade growth; growth in externally-oriented sectors is the productivity growth engine of small advanced economies. There is a tight relationship between world trade growth and labour productivity growth in small advanced economies. But a recovery in world trade this year may support increased productivity growth, reinforced by increased investment in capex, technology, and R&D in many small economies.
These recent productivity growth dynamics have shaped variation in inflation performance across economies. It is striking that the US has managed to bring down inflation meaningfully without causing damage to the real economy; this has been supported by stronger labour productivity growth. In contrast, inflation is proving stickier in lower productivity growth economies, even with weaker GDP growth such as the eurozone and the UK.
This is also the case in New Zealand and Australia, where labour productivity growth has been weak. New Zealand’s labour productivity was an awful -5.6% in the year to Q3; Australia’s labour productivity growth was -2.1%. In both countries, record immigration has bolstered hours worked, without lifting GDP proportionately. In this context, GDP growth is inflationary, because the economy has lower speed limits. Indeed, New Zealand’s inflation is proving persistent, with interest rate increases now being picked by some.
Productivity renaissance
Beyond this near-term relationship between productivity growth and inflation, there are structural dynamics to consider. Looking forward, generative AI and related technologies will likely have a meaningful impact on productivity growth. Generative AI is a general purpose technology that will impact large swathes of the economy, with relatively low barriers to widespread deployment.
Goldman Sachs, McKinsey, and multiple academic studies point to the substantial productivity growth that this technology can deliver in sectors across the economy from life sciences and energy to coding and call centres.
Firms are making substantial investments in AI, and the pace of technological progress is remarkable. Nvidia’s blowout results on Wednesday (with market cap now up 4x on a year ago, at almost US$2 trillion) provide a sense of the scale of these dynamics. Nvidia CEO Jensen Huang claimed there was a ‘tipping point’ in generative AI, with demand ‘surging worldwide across companies, industries and nations’.
Rapid technological progress is also underway elsewhere, from quantum computing and fusion to energy storage and life sciences, with the potential for material productivity impacts.
Periods of higher productivity growth tend to be periods of subdued inflation, such as from the mid-1990s. So looking forward, the inflation trajectory will be shaped by the tension between the structural pressures of a high-pressure, wartime economy against the deflationary effect of stronger labour productivity growth.
The case for structurally higher inflation is strong, as described at the top of this note, and there is historical backing for it. But a scenario in which the supply side of the economy expands significantly, allowing extra output to be produced without producing inflationary pressures should be taken seriously.
There is significant uncertainty about the strength of these forces. It is too early to say anything with much confidence on the strength of the productivity renaissance scenario, although the recent US productivity data – where investment in AI and other technologies is most advanced – is encouraging. But the scenario is plausible, and another few positive productivity surprises will strengthen its likelihood.
And either way, firms and economies need to be investing heavily behind productivity - or risk being stranded well behind the shifting productivity frontier.
Overall, my baseline view is for structurally higher inflation over the next decade at least – but for strengthened productivity growth to dampen these structural dynamics. The world continues to move away from the low numbers we have experienced since the global financial crisis: expect higher GDP growth, stronger productivity, as well as higher inflation and rates. It’s time to position for a new world.
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