Productivity Miracle Postponed- The Fed Needs To Do More Tightening

The Fed and market bulls have been making the case that the immaculate disinflation/”golden path” could be achieved via a productivity boom that was upon us, driven by the combination of AI and immigration putting downward pressure on prices.

Supply side driven forces that create a productivity miracle while displaced workers from AI are dealt with increasingly by the government sector whose deficits start to fall over time because of the higher tax receipts that come from the virtuous profit cycle created. This is the dream.

However, given the debt and deficit levels in the US today, this AI boom needs to be even bigger than the productivity boom we had in the 1990s from the Internet adoption in order to prevent the structural inflation that results from running these accelerating government deficits from continuing. 

My suspicion is that it is a bit too early to claim that the productivity miracle is upon us and this idea that the economy will not need some more pain in order to bring inflation down is a bit ridiculous. 

Well, this morning’s data on productivity and unit labor costs confirm my suspicions that this “miracle” is nonsense. Nonfarm productivity missed, coming in at 0.3% vs 0.5% expected and a downshift from 3.3% in the 1st quarter. Unit labor costs exploded higher to 4.7% vs 4.0% expected and 0.4% last quarter. Cmon folks, enough is enough. 

The Fed needs to stick to the script and stop getting enamored by narratives created by petulant market participants in constant need of liquidity. 

There is a reason Bostic mentioned the idea of “pent-up exuberance” in his district coming from the notion that the Fed was beginning a rate cutting cycle too soon. The economy acts in real time to rapid changes in financial conditions. The idea of the impact of monetary policy through long and variable lags is much more muted for a highly financialized economy that has locked in long term low borrowing costs for the household and corporate sector but has not locked in such low costs for the growing public sector who continually has higher and higher deficits that need to be financed. 

Yesterday, Powell was once again more dovish than the hawks on the committee yet doesn’t speak for all of them. In his prepared remarks, he removed the phrase “we believe that our policy rate is likely at its peak for this tightening cycle,” which certainly was a bone thrown to the more hawkish voting bloc as Powell cannot begin an easing cycle with dissenting votes in an election year. He also dodged the question about whether rate hikes were discussed at this meeting which suggests that they were. He probably didn’t want to open that can of worms but after the data out again this morning and what is likely to come tomorrow from payrolls and services ISM continuing to show strength, I would expect the hawks to push back on Powell’s dovish performance and remind market’s that rate hikes are in fact on the table again if this momentum continues. 

Keeping rate hikes as a growing probability is the way to dampen animal spirits, bring down inflation expectations and return inflation to 2%. The labor market can handle it at this point. The more Powell talks up asymmetry in his rate outlook where the bar to cut is lower than the bar to hike, the more than market will make it difficult to achieve the last mile. 

Time for Powell to slam the door. Admit mistakes and move on, return inflation to 2% by letting market forces do what they need to do. 

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