Bernanke's Productivity Speech Raises Questions About Current and Future Inflation

Federal Reserve Chairman Ben Bernanke spoke yesterday about productivity in the American Economy. Reading his speech raised some questions about the relationship between economic growth, productivity, and inflation. He says:

From the end of 2000 to the end of 2003, productivity rose at a 3.5% annual rate and, even after recent downward revisions to the data, it is estimated to have increased at an average annual rate of 2.25% since the end of 2003.

There was not a high GDP growth rate over this period of time (2.8% annually). It is obvious that productivity gains are laggards of investment, but if the economy wasn't growing quickly and inflation wasn't rising quickly, then where did the excess money go? As I see it, there are three answers. One being strong corporate profits due to higher margins from cost savings from the uptick in productivity. I don't believe this is the case because competition, especially foreign competition, would keep margins low. Also, the American economy was just recovering from a mild recession and not yet experiencing strong corporate profits. The second explanation would be an increase in wages. This is what most economists have expected but not seen. It is believed that productive workers, if not given raises, will switch firms or even industries where their productivity is more highly valued in the competitive labor market. This has not happened and it seems to be bewildering economists. The third explanation, and the one I am most intrigued by, deals with inflation. I believe the higher margins caused by the productivity gains were reinvested back into the business to increase output at this new found more productive and cheaper level. This increased the supply of goods in the marketplace and kept prices and inflation pressures low. These productivity gains explain why the long period of easy money policy by the Federal Reserve resulted in low rates of inflation coupled with strong economic growth. Goods were able to remain cheap due to cost savings provided through productivity gains. The strong demand for goods created by the availablity of cheap money was filled by the increased production of goods through investment in production I outlined earlier. I believe current inflation pressures are still being held down by the productivity gains experienced in the early years of this decade. As Bernanke said referring to this period:

...productivity growth generally varies with the business cycle, tending to be below its longer-term trend when the economy is contracting and above that trend when the economy is in the early stages of an expansion. This well-documented pattern makes the strong growth of productivity during the early part of this decade, a period that featured a recession and generally slow growth, all the more remarkable.

Looking forward, with productivity increasing by 2.25% since the end 0f 2003, I see a slowing economy, but surely not a recession. The current rate is still good enough to offset some of the inflation pressures into the future. As Mr. Bernanke put it:

..the rate of productivity growth is a primary determinant of economic performance.

and

Economists agree that, in the long run, productivity growth is the principal source of improvements in living standards.

As long as barriers to innovate are low and incentives high in the United States, I foresee these historically high increases in productivity offsetting some the economic problems that we may encounter such as inflation and high energy prices.