America’s labour productivity is rising—This should imply a higher neutral rate of interest and tighter Fed policy

American labour productivity, or non-farm employee output per hour, increased at a 4.9% annualized rate in the third quarter, the strongest since 2023, according to the Bureau of Labor Statistics. Excluding the bounce-back quarters around recessions, it was the second-strongest reading in two decades. Meanwhile, unit labour costs plunged for a second consecutive quarter, dropping 1.9% after declining 2.9% in the April through June period.

Taking them at face value, rising productivity and lower costs are worthy of celebration. America’s increasing efficiency is creating conditions for a continued slowdown in inflation that has been happening for three years even as the economy powers ahead and the stock market scales record highs.

And yet, no one can say for sure what’s behind the numbers, whether it will continue and what it means for interest rates. And that goes for Fed policymakers as well, who would do well to exhibit some humility in the months ahead.

So is it AI? Maybe. The most obvious explanation is often the right one. According the Census Bureau’s Business Trends and Outlook Survey, around 18% of US firms report having used AI in the past two weeks. That’s more than triple the adoption in early 2024. (Granted, a recent jump in the numbers probably reflects a reframing of the survey question: The Bureau used to ask firms if they were using AI for “the production of goods and services," but now they ask if they use it for “any business function."

Estimates of how AI will ultimately affect productivity run the gamut, but it’s probably a game-changer for several types of knowledge work. One marketing experiment conducted by researchers Harang Ju and Sinan Aral found that human-AI teams were a shocking 73% more productive than all-human teams. In software development, another study found that developers using an AI tool completed 26% more tasks.

To be sure, ‘old economy’ businesses may struggle to find highly effective uses for the tech. Consider taxi drivers presented with an AI tool to find customers: The tool yielded a modest 7% productivity boost to low-skilled drivers but a near-zero impact on the performance of drivers who were already good at their jobs. Evidently, the usefulness of AI is not only dependent on industry and context, but on the starting skill levels of the humans using it.

As for policy implications, those too are hazy. While lower unit labour costs are disinflationary, higher productivity is typically associated with higher demand for investment capital and a higher potential GDP growth rate. On balance, that can help raise the ‘neutral’ rate of interest, which is the rate at which monetary policy neither restrains nor fans economic growth.

If policymakers focus on the first order effect (lower unit labour costs) and ignore the neutral rate channel, they might be inclined to slash rates and leave financial conditions unduly loose, potentially fuelling bubbles in financial assets or sparking faster inflation.

Fed Governor Stephen Miran told Bloomberg Television last Thursday that, after cutting its benchmark rate by 75 basis points from a range of 4.25% to 4.5% in September to the current 3.5% to 3.75%, he would like to see the central bank reduce them by an additional 150 basis points this year to a 2% to 2.25%, predicated on the idea that monetary policy is currently restrictive and inflation is under control.

And yet, a separate report last week by the Federal Reserve Bank of New York showed that consumers expect faster inflation in the next 12 months, or 3.42%, up from 3.20% in the November survey and moving further away from the central bank’s 2% target. After five years of elevated inflation, policymakers need to keep a close eye on inflation expectations, because faster inflation can sometimes become a self-fulfilling prophecy.

Unfortunately, the neutral rate is just as enigmatic and unknowable as labour productivity. Given that inherent uncertainty, the proper course of action would be to proceed slowly and wait for further data on productivity, inflation and the labour market.

Central banking requires extraordinary humility even in normal times, and that’s doubly true when you are potentially on the cusp of a potential productivity revolution. ©Bloomberg

The author is a columnist focused on US markets and economics.