The Supply Problem In The Fed's Framework - Part 2: Did The Fed Miss A Productivity Boom? The Future Warrants More Attention & Agility
This is the second post in our multi-part series on the Fed's 2025 framework review. Part 1 can be found here. The Fed has an opportunity to learn valuable lessons and apply those lessons in a forward-looking manner. By revising its framework accordingly, Fed policy can be more robust in response to supply shocks and more supply-aware in its strategy and communications.
Virtually all economists will point towards the importance of productivity in determining long-term standard of living, but do they pay close attention to the data as it unfolds? After a decade-long assumption that productivity growth would stagnate around 1% to 1.5% per year, the last five years have shown a material acceleration up to 1.9% per year. The Fed has shown little awareness of the shift, but with new shocks potentially forthcoming, it’s time for the Fed to demonstrate a more agile approach to evaluating and communicating productivity dynamics. After all, shifts in productive capacity shape outcomes relevant to the Fed’s Congressional mandate, including the "dual mandate" objectives of maximum employment and stable prices. The Fed’s framework review provides an opportune moment to update their approach
The December 2019 Tealbook Productivity Forecast Was Off By Over 4%
In December 2019, the Fed staff’s Tealbook forecasts projected long-run productivity growth of about 1.4% per year. This estimate was towards the generous end of what realized longer running trends of productivity were showing. In the period initially following the global financial crisis, productivity growth was closer to 1% per year.
Since December 2019, through all the twists and turns of the pandemic, the supply shocks that wound and then unwound, productivity has grown half a percentage point faster per year. That is a sizable difference when compounded over time. Nonfarm business output per hour is now more than 4% above what the Fed projected before the pandemic, and what realized trends suggested even in the data we saw at the moment the pandemic began to unfold.
This should be good news. The economy’s capacity to produce goods and services has grown faster than expected, suggesting more room for healthy wage and income growth without triggering inflation.
The Fed has yet to adjust its projections or policy stance to reflect this shift. As a result, observers of the Fed's decisions can be left confused. The Fed chose to cut interest rates in late 2024 even as real GDP grew at roughly 3% per year across 2023 and 2024. But with the knowledge of positive productivity impulses, that reconciliation would be clearer. We have just gone through a period where strong real output growth coincided with slowing growth in hours worked and prices.
Looking Through the Pandemic-Induced Volatility
Productivity data has been volatile over the last five years. Early in the pandemic, measured productivity spiked as employment fell faster than output. This is likely a distortion as employment falls more precipitously than output in modern recessions. The full costs of unemployment to output and productivity materialize with a lag. As employment recovered, so too did productivity estimates locally stagnate. But coincidentally to this employment recovery dynamic were supply-side disruptions like the global microchip shortage, which sharply restricted production and raised prices for an array of durable goods and associated services. Surging energy, metal, and agricultural commodity prices after Russia’s invasion of Ukraine further depressed output, and thus dragged on productivity measures.
But these distortions were ultimately temporary and understandable. As supply shocks faded, productivity rebounded. By 2023 and 2024, productivity growth caught up to and then later surpassed the pre-pandemic trend. The recent acceleration reflects real underlying improvements and cannot simply be set aside as statistical noise.
Employment & Productivity Can Partially Reinforce Each Other
Discussions of productivity outcomes rarely overlap with discussions of business cycle employment outcomes, and yet history suggests otherwise. Looking across the past 40 years and looking through the mean-reverting distortions associated with recessions, prime-age employment-population rates tend to positively correlate with 1-year forward productivity growth. In other words, better performance on the Fed's maximum employment mandate may, all else equal, support additional productive capacity and ease future tensions within the Fed’s “dual mandate” between inflation and employment.
Why? The answer likely relates to how accumulated work experience supports human capital deepening and labor market dynamism. Workers are likely better positioned to scale revenue and real production growth for firms if (1) they are employed and utilizing their skills more continuously, and (2) able to form better matches with their employer. These dynamics support real wage growth and productivity, and help explain some of the recent variation in productivity, both relative to recent US history and across countries.
The Risks Of Willful Ignorance
If productivity is stronger than the Fed expected, that may have important implications for how the Fed approaches and communicates its monetary policy decisions. The economy demonstrated more room to grow without creating upward price pressures, relative to what the Fed anticipated. Some of the inflation we’ve experienced may be better explained by fading supply constraints, not overheating demand. To the extent it is identifiable that productivity is outperforming and why, the Fed should be willing to adapt their assessments of maximum employment and price stability risks accordingly.
At the same time, it is clear that productivity can also take turns for the worse. Oil price shocks caught policymakers off guard in the 1970s. Cost-push inflationary shocks in the early 90s and mid-2000s were similar in kind even if not in scale. And with the the scale and scope of proposed tariffs, we can't simply ignore the risk of adverse productivity shocks now. At least in the short run, the proposed policies put the dual mandate objectives of employment and inflation in firmer tension, precisely because they undermine productive capacity. If prices spike, we are likely to coincide with weaker real income and consumption outcomes. If they lower investment, that too will weigh on productivity growth, but in a manner that might strain the maximum employment mandate more imminently and destabilize prices with a longer lag.
As with all “one-off” policy-related effects to productive capacity, they are ultimately time-limited in how they shape the Fed’s outlook. Firms will ultimately adjust to new uncertainties and a new policy regime. Nevertheless, they are relevant to the Fed’s communications, especially over the time horizon in which they make public macroeconomic projections (1-3 years). The Fed should be able to convey to the public how identifiable dynamics and data developments are shaping productivity outcomes over short to medium run, and they can still do so while staying firmly restrained to the mission Congress has assigned them. In so doing, they can clarify how different constellations of data cohere with their understanding of the dual mandate.
We’ve seen recently how strong real GDP growth in 2023 and 2024 might still be consistent with lower inflation and interest rate normalization, just as we saw how weak real GDP growth in 2022H1 was consistent with accelerating inflation and interest rate tightening. The unsaid driver behind these outcomes were fundamentally on the supply-side: productivity growth.
A clearer approach to discussing productivity dynamics can be especially helpful to the public to decipher why the Fed is choosing to tighten or loosen policy. We may enter periods of weak real output growth even as employment and inflation outcomes warrant tighter policy. Monetary policy's effect on financing conditions and employment outcomes may have their own supply-side effects that warrant consideration from policymakers, especially when coming out of a recession. If the Fed leaves the public completely in the dark on these matters, conflicting data points could easily sow more confusion and mistrust around key policy decisions. More importantly, if the Fed's framework still leaves supply-side assessments and communications in the blind spot, the Fed risks lagging behind critical shifts in business cycle dynamics.
Conclusion: Transparently Communicating The Role of Productivity Dynamics In Shaping Policy Tradeoffs
The Fed has an opportunity to recognize that even as there is much to worry about in the world, there are also pathways to better outcomes than they may currently expect. Today’s worries about tariffs are bigger in scale to what the Fed faced in 2019, but it is still instructive that the Fed can now look back to the 2019-2024 period and see productivity outperformance that spans the better half of a decade. The future inevitably surprises.
The Fed can leverage the framework review to take a more attentive, agile, and data-driven approach to assessing supply-side dynamics. The last 5 years of productivity growth were anything but static or irrelevant to monetary policy tradeoffs. The Fed cannot expect productivity growth to be static over the next five years either; Fed communication should reflect that ever-changing reality. There may be setbacks in the short run even as foundations are laid for stronger productivity growth over the medium and longer run. On the other hand, the inverted circumstance seems just as plausible. A recession may spur an artificial windfall of measured productivity gains only to reverse as employment begins to recover.
From recessions to full employment, supply chain outages to commodity price volatility, there is much we’ve learned in the past five years about how macroeconomic phenomena, the supply side, and Fed policy intersect. If productivity is as important as Fed officials like to profess, they would do well to reflect that view when considering revisions to their consensus statement this summer.