Inflated expectations

In a world where rampant technological innovation and globalisation continually increase the efficiency of every aspect of life, it is more difficult to see how long-term inflation could ever reach historical norms.

With greater efficiency comes greater productivity and, by extension, greater slack in the economy. The days of carbon-copy paper are not that far in the past, the internet is still less than 40 years old and the pace of innovation seems to continue its staggering march as we enter the world of 3D printing. How long can it be before something purchased online is simply ‘printed’ in a purchaser’s home, cutting out huge swathes of production, marketing, delivery and all the associated industries and people required to carry out those functions?

Mechanisation and globalisation in combination have historically worked to massively increase the efficiency of how the factors of production are employed worldwide, including significantly reducing the need for human capital despite increasing longevity and the constant upward creep of retirement ages. London Underground ticket officers, as a small example, are already well aware of their replaceability with machines.

But, despite all the gains of recent years, productivity has stalled, especially in the UK.

THE PRODUCTIVITY PUZZLE

“The central question for economists and policy makers revolves around productivity,” says Simon Hill, chief investment officer, Buck Global. “Productivity is lower than it should be given the productivity growth trends seen pre-crisis, and the problem is markedly worse in the UK.”

Figures from JP Morgan Asset Management (JPMAM) show UK productivity, as measured by output per hour worked, maintained a steady upward march from 40 at the end of Q1 1971 to a peak of 103.5 at the end of Q1 2008. A year later, it had fallen to 99 and has remained in a tight range around that level since, measuring 99 again at the end of Q1 this year. (See chart)

“Over the last hundred years, productivity has grown at a consistent rate, but this time it has been knocked off course,” says Alex Dryden, market analyst within JPMAM’s Global Market Insights Strategy team.

“We should have seen productivity continue to come through, but then the financial crisis hit. It has flatlined since and the Bank of England is a little stumped as to why.”

The Bank of England’s Quarterly Bulletin Q2 2014 estimated output per hour remains around 16% below the level implied by its pre-crisis trend. The Bank’s Monetary

Analysis Directorate says the shortfall, or ‘productivity puzzle’ is large, even taking account measurement issues and secular changes in some sectors.

Their analysis suggests the stagnation of productivity has been caused by a range of cyclical and more persistent factors, including labour-hoarding in the initial phases of the recession, companies having to work harder to win new business as well as lack of investment by companies in both physical and intangible capital, and an impairment of resource allocation from low to high productivity uses.

“But there remains a large degree of uncertainty around any interpretation of the

weakness in productivity,” according to the Bulletin, which concedes: “The explanations covered in this article are unlikely to be exhaustive and are unable to explain the full extent of the productivity shortfall,”.

Historically, capital expenditure by companies following a period of recession has taken around two years to return. This time, however, it is taking considerably longer for corporate confidence to reach a level where they are willing to part with their significant cash piles. As they do, productivity will begin to increase, but the lack of growth over the last five years will likely have a lasting effect.

“It is likely we will make up some of the gap between where productivity should have been and where it is now,” according to Dryden, “but a certain amount has been lost for good.”

SPARE CAPACITY

Lack of productivity growth is a problem for pension funds because it has a knock-on effect on the amount of spare capacity in the economy. The less spare capacity exists, the sooner inflation will strike, the faster it will climb and the harder it is to control.

Spare capacity is the difference between current economic activity and the potential level that would be consistent with stable long-term inflation. The Office of Budgetary Responsibility (OBR) calls this the ‘output gap’ and currently estimates it to be around -1.7% of potential GDP.

However, in the broader markets, Buck’s Hill believes: “Some experts believe there is no spare capacity, others say it is just hidden, but there is an overall shift towards people worrying spare capacity is not there.”