Can Demand-Side Policies Push Productivity? Policymakers Will Try

Summary

• Policymakers are beginning to wonder whether demand-side policies can positively effect productivity.
• Yellen commented five years ago that policymakers may want to be more accommodative during recoveries. Her words are now particularly relevant and supportive of risk assets and the US economy.
• The next market re-rating could come from an upward revision in 2022 growth forecasts.

In January, an NBER paper addressed an economics topic that policymakers are seemingly relitigating. Can monetary policy/demand-side policies affect the economy’s supply side?

The traditional thinking on this subject more generally and on total factor productivity (TFP) is that productivity is orthogonal to structural shocks that move aggregate demand, such as monetary shifts. As the economist Robert Solow noted, ‘Economic output over the longer term is primarily driven by supply, the amount of output of goods and services the economy is capable of producing, given its labor and capital resources.’ 

Yet the NBER paper finds that monetary easing generates a pro-cyclical response in aggregate TFP, while also noting that TFP as measured by the Solow residual is sensitive to nominal demand shocks.

Academic interest aside, this paper is compelling because it reminded me of a famous speech from former Fed chair Janet Yellen speech from October 2016. At a research conference at the Boston Fed, Yellen posed a similar question: ‘Are there circumstances in which changes in aggregate demand can have an appreciable, persistent effect on aggregate supply?’ 

Prior to the Great Recession, most economists would have said no. They would have said that Solow was right – supply drives economic output over the long run. They saw aggregate demand only as explaining shorter-term dynamics. That said, hysteresis is not such a new concept; researchers Olivier Blanchard and Lawrence Summers wrote about it going back to European labour markets in the mid-1980s.

And while Yellen left it as an open question, the then-chair of the Federal Reserve said a few things on this subject that were especially forward looking. Given she is now Treasury secretary, this sort of framework becomes even more important.

• ‘The natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high pressure” economy, with robust aggregate demand and a tight labor market.’
• ‘Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects.’
• ‘Strong demand could potentially yield significant productivity gains by, among other things, prompting higher levels of research and development spending and increasing incentives to start new, innovative businesses.’
• ‘If strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view.’

It seems this coming economic cycle will be so different partly because policymakers are beginning to wonder whether demand-side policies can positively effect productivity. In that context, as Yellen put it five years ago, ‘Policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view.’

From a policymaker perspective, demand-side policies will no longer be considered as one-time effects on output. That should be immensely supportive for risk assets and the US economy. Yellen’s 2016 speech may help establish her eventual legacy at the Treasury.

The next market re-rate could come from an upward move in 2022 growth forecasts. Markets continue to consider demand side policies from a ‘flow’ perspective. What if they have a ‘stock’ element, as Yellen effectively noted?