PNC presented its economic outlook to the Detroit Economic Club on March 16. PNC is mildly optimistic towards growth, projecting real GDP growth of 2.5 per cent over the next two years, compared to the consensus projection of 2.3 per cent. Growth expectations for PNC and consensus are low compared to the trend growth rate of 2.8 per cent from the last 34 years, because expectations for productivity growth remain low. Since 1983, trend productivity growth has been 2.2 per cent and the consensus projection for productivity growth is just 1.6 per cent.

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The decline in productivity growth in the last decade seems counterintuitive, given the technological innovations that change our daily lives almost routinely. There are two explanations for what appears to be counterintuitive.

The first explanation is that we have only just begun to utilize the excess capacity in the economy that was built up prior to the recession of 2008-2009. Most GDP improvement has come from putting people back to work, rather than investment. Under this explanation, a normal level of productivity growth is about 2.2 per cent (the 34 year trend growth) and we will revert to a normal level of productivity growth soon, given that wages have started to rise giving firms more incentive to invest in facilities rather than hire people at higher rates.

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A second explanation is that there are benefits from technology which do not show up in gross domestic product and therefore productivity gains. Technological innovation benefits workers in a myriad of ways, including time saving, ease of access to information, and on-demand entertainment. So we have some innovations that improve quality of life, but which do not show up as increased output. Under this explanation, productivity growth will remain below the trend growth rate of 2.2 per cent.

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Both these explanations have merit. We are unlikely to see productivity growth of 3.5 per cent – the last 10 year period in which this occurred ended in 1969. But productivity as a measure of innovation in the economy does suffer from leakage – technological improvements lead to benefits that don’t show up in productivity statistics because workers’ objective is not to use every time saving innovation to simply perform more work.

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Introduction

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Stuart Hoffman, PNC’s Chief Economist, presented the PNC outlook for the national economy and Detroit at the Detroit Economic Club meeting on March 16. We present the PNC forecasts in the context of economic outcomes over the last 34 years, and consensus expectations based upon the U.S. Federal Reserve’s quarterly survey of professional forecasters. The performance from 1983 onwards is a relevant comparison because this coincides with the current monetary policy approach of the Federal Reserve to maintain inflation at a low, stable level.

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GDP growth and productivity

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Compared to consensus, PNC is more optimistic on growth. PNC projects real growth in GDP of 2.4 per cent and 2.7 per cent over the next two years, which corresponds to an annual rate of 2.5 per cent. In contrast, consensus estimates are 2.3 per cent and 2.4 per cent in 2017 and 2018, or an annual rate of 2.3 per cent. Both PNC estimates and consensus estimates of GDP growth fall below the trend economic growth of 2.8 per cent observed since 1983.

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Economic growth has been consistent, but below average, since the recession of 2008 to 2009, because labor productivity growth has been below average. The Bureau of Labor Statistics compiles a quarterly estimate of labor productivity – an estimate of aggregate output of goods and services relative to total hours of labor. This is an imperfect measure of productivity because the composition of the economy changes over time. But it gives us an indication of whether the economy is growing because of innovation and effective use of capital, or because the labor force is expanding.

 

From 1983 to 2016 productivity increased at an annual rate of 2.2 per cent. But productivity growth has been less than 1 per cent each year for the last six years. The consensus forecast for productivity growth over the next 10 years is an annual increase of 1.6 per cent. In sum, forecasters expect the economy to grow at an annual rate of 2.3 per cent, with 1.6 per cent growth from more productivity, and 0.7 per cent growth from a larger workforce.

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PNC did not make a specific forecast of productivity growth. But Mr. Hoffman did discuss productivity as one reason why GDP growth is projected to be below what we have observed in the past. His comment is that “the types of productivity gains required to achieve more than a few quarters of 4 per cent real GDP growth would be larger than those ever experienced in the post-World War II United States.”[1]

 

 

 

 

 

 

 

 

 

 

 

 

 

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The PNC comment somewhat understates the potential for large productivity gains, as we did see an surge in productivity growth over the decade from 1996 to 2006 to 3.2 per cent. But this represents the period of unusually high productivity growth compared to recent decades. The other four decades in the last 50 years have seen productivity growth within the range of 2.3 per cent (1956-66) to 1.2 per cent (2006-16).

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The decline in productivity growth in the last decade seems counterintuitive, given the technological innovations that change our daily lives almost routinely. There are two explanations for a discrepancy between the impact of technology on day to day activities and the measured change in productivity.

 

Excess capacity following the recession

 

One explanation for lower productivity gains in the last 10 years is that, following the recession, most GDP improvement has come from putting people back to work. So we have seen increases in economic activity, but also increases in labor hours. When you have excess capacity in facilities and plenty of workers to call upon then there is less incentive to make investments that show up in productivity gains. Under this explanation, a normal level of productivity growth is about 2.2 per cent (the 34 year trend growth) and we will revert to a normal level of productivity growth soon, given that wages have started to rise giving firms more incentive to invest in facilities rather than hire people at higher rates.

 

Technological impacts outside the workforce

 

A second explanation is that there are benefits from technology which do not show up in gross domestic product and therefore productivity gains. In a general sense, the amount of output we can count has increased slowly relative to hours worked, but workers receive other benefits from technology (time saving, faster access to information, entertainment). Some people will use that extra time and information to be more productive (more school, work another job, work more at home rather than use contractors) but others will simply have more leisure time and more entertainment during that leisure time. So we have innovations that improve quality of life, but that doesn’t show up as output.

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Both these explanations have merit. We are unlikely to see productivity growth of 3.0 per cent to 3.5 per cent which we observed in the two decades following World War II. There has not been a consecutive 10 year period when productivity growth hit 3.5 per cent since 1969. But productivity as a measure of innovation in the economy does suffer from leakage – technological improvements lead to benefits that don’t show up in productivity statistics because workers’ objective is not to use every time saving innovation to simply perform more work.

 

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Unemployment and inflation

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The PNC projection for the unemployment rate is 4.5 per cent over the next two years, which is in line with consensus expectations of 4.5 per cent to 4.6 per cent over 2017 to 2021. The low level of unemployment is projected to lead to wages increases and therefore higher inflation than we have seen in recent years. PNC projects that the average hourly wage will increase by 2.9 per cent a year over the next two years to $22.84.

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It is on wages, employment and inflation that we can draw some inferences that are directly applicable to the Detroit market. Household incomes and house prices are projected to rise, but this increased income and wealth will be offset by increased borrowing costs. PNC projects that median household income in Detroit will rise from $55,000 at the end of 2016 to $56,000 by the end of 2017. [2]Over the same time period, PNC projects annual inflation at the national level of 2.3 per cent,[3] prompting the U.S. Federal Reserve to continue to raise interest rates. In turn, the fixed interest rate on a 30 year mortgage is projected to increase to an average of 4.5 per cent over 2018, up from an average of 3.6 per cent in 2016.[4]

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[1] PNC National Economic Outlook, February 2017, p. 2.

[2] PNC Detroit Market Outlook, 1st Quarter 2017, Chart 2, p. 1.

[3] PNC National Economic Outlook, February 2017, p. 1.

[4] PNC National Economic Outlook, February 2017, Expanded table.