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Is more hiring the silver lining of lower productivity growth?

Brent Nyitray, CFA, MBA

Productivity is a measure of output per unit of labor 

Productivity increases allow wage increases without increasing inflation. The sister index to productivity is unit labor costs, and unsurprisingly, the Bureau of Labor Statistics releases them together. Non-farm productivity is calculated by dividing an index of output by an index of hours worked. Productivity growth is good long-term for the economy, but it can have painful short-term consequences in that it reduces demand for labor. With the amount of slack currently in the labor market, that’s a recipe for elevated inflation. In fact, the most recent recessions have been marked by high productivity gains. This has led to “jobless recoveries.”

Historically, the Fed has paid close attention to productivity and unit labor costs as inflationary indicators. In the current economic environment, the Fed believes it’s failing in its dual mandate with respect to unemployment and inflation. It would like inflation to be higher than it actually is. While this may sound counter-intuitive, remember that it’s real (inflation-adjusted) interest rates that matter to the economy—not nominal inflation. With the Fed at the lower bound (interest rates can’t go below zero), decreases in inflation actually increase real interest rates, which is the last thing it wants to do. It would much prefer to run inflation around 2% in order to achieve as close to negative real interest rates as possible.

Highlights of the report

Productivity increased at a 1.9% annualized rate for the third quarter of 2013, as output increased 3.7% and hours worked increased 1.7%. This was lower than the Street estimate of 2.2%. This is an increase from the second quarter of 2013 (when productivity was 1.8%) and the first quarter, which was -1.7%. Unit labor costs fell 0.6%. This was the preliminary estimate of both numbers for the third quarter.

The silver lining of the report is that companies have probably squeezed all they can out of their current workforce and will need to hire in order to grow. This should bode well for the economy going forward.

Implications for mortgage REITs

The increase in productivity means the Fed is feeling no inflationary pressures that would induce it to raise interest rates. The latest Federal Open Market Committee (FOMC) statement clearly said that as long as unemployment was above 6.5% and inflation was less than half a point above the target rate of 2%, the Fed would maintain exceptionally low (read zero) interest rates. Most forecasts have the Fed increasing rates sometime in 2015 or 2016.

Agency REITs—like Capstead (CMO), American Capital (AGNC), and MFA Financial (MFA)—have less credit risk than non-agency REITs, like PennyMac (PMT) or Two Harbors (TWO). But they have a lot more interest rate risk. Agency REITs invest in mortgage-backed securities that are guaranteed by the government, while non-agency REITs don’t. Government-guaranteed mortgages have much lower yields than their non-guaranteed counterparts. This means that agency REITs must use more leverage to generate an acceptable return. The combination of high leverage and highly sensitive mortgages means that the agency REITs are extremely vulnerable to interest rate shocks. The last time the Fed unexpectedly raised interest rates was in 1994, which was when Orange County declared bankruptcy after experiencing heavy interest-rate driven losses on agency paper.

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