Productivity is the wild card in US monetary policy. This winter, for example, some economists have been arguing that the Federal Reserve Board was too tight on monetary policy too long because it failed to recognise productivity growth sufficiently. Over a period of years, the Fed underestimated the exceptional increases in America's productivity rate and overestimated the potential for inflation. The unnecessarily high interest rates the Fed applied then provoked the fourth quarter slow down, which in turn forced Fed Chairman Alan Greenspan and his board into an embarrassingly hasty volte face on rates.

Now one member of that board, Governor Edward M. Gramlich, has come forward with some insights into the American productivity mystery. In a speech last Tuesday before the International Bond Congress in London, Mr Gramlich offered a few explanations for why US labour productivity increases in the latter half of the 1990s were so disconcertingly strong vis a vis those of Europe. Then he suggested that the US changes mean it's time to re-engineer the Fed's inflation meter, and make it more like Britain's.

In the first half of his argument, Mr Gramlich resumes the latest work in the productivity area, focusing especially on a paper by two Fed economists, Christopher Gust and Jaime Marquez. The pair analysed data from the Organisation for Economic Cooperation and Development for 13 countries. Specifically, they sought to shine light on the murky area of multifactor productivity, a subset of labour productivity. These are changes in worker productivity that occur independent of the supply of capital. Things that can boost multifactor productivity include using information technology efficiently, installing servers to rationalise computer use, and so on. (Economist Robert Gordon has also done a lot of work in this area).

The authors found that multifactor productivity did much to give America its edge in the 1995-2000. America and Australia were the only two countries in which the increases in multifactor productivity were significant; their productivity also increased strongly. Meanwhile, MFP growth was slowing in much of Europe and in the lagging Netherlands, MFP decreased.

Mr Gramlich then crunches some numbers himself and concludes that IT's role was crucial. If Europe had had more internet servers per capita, or if European businesses had spent even more heavily on IT, they might have had an easier time keeping pace with the US.

But if Europe offers no model for generating productivity increases, it may have one for managing them. Versions of inflation targeting, in which price levels automatically force adjustments to interest rates, are practiced by the ECB and the Bank of England. Mr Gramlich suggests that in the new and confusing era, inflation targeting might also be a good regime for America's central bank. "In forward looking, flexible inflation targeting," writes Mr Gramlich, a central bank would try to steer the economy toward some target rate of core inflation: "This means that if recession threatens, actual inflation is likely to come in below the target level, inducing a central bank following FFIT to ease policy, limiting the recession..."

Mr Gramlich's model for inflation targeting is not perfect. Instead of backing pure price targeting, he recommends something of a hybrid: his plan includes a requirement that central bankers review the level of resource utilisation, aggregate demand, and other old, standard functions. Still, his analysis also carries a message for his own Fed colleagues and US lawmakers who oversee America's monetary laws: inflation targeting might have smoothed this winter's bumpy ride.

© Copyright 2001 Financial Times