The release of the latest data on US labour costs and productivity growth introduced a disagreeable element into the calculations of many investors. Inflationary pressures may be more problematic and Fed policy direction more uncertain than they had previously thought.

In the third quarter, non-farm productivity growth stalled and unit labour costs surprised to the upside. Some people may interpret the data as a one-quarter anomaly, but others who are focussing on longer-term trends have already formed expectations of slower average productivity growth in the future.

Previous to the current release, an earlier re-working of historical data by government analysts resulted in a downward revision of productivity figures. The overall results give credence to an expectation of more modest performance, going forward. It is an important issue because an economy’s productivity and growth potential have significant consequences for inflationary pressures, living standards, international competitiveness, corporate profitability and government policy options.

It’s a big topic, but an important one, and to get a handle on it we have to conduct the analysis in stages. The main factors that enter into the determination of an economy’s potential growth are: (a) capital investments (b) technological change (c) growth in labour supply.

Looking at the historical record, US non-farm productivity grew at a high average rate during the 1960s, downshifted to a much lower rate from the mid-seventies to the mid-nineties and then accelerated rapidly from 1995 onward but has started to slip in the past two years. Such changes aren’t unique to the United States and occur in other economies too.

Many emerging countries have, in recent years, experienced higher productivity as a result of structural reforms, opening up of the economy and the benefits of globalisation. Meanwhile, there are indications that both Europe and Japan are set to display better performance in the future.

One thing to note is that we are primarily focussing on structural rather than cyclical issues. Productivity and unit labour costs rise and fall over a business cycle as output and employment fluctuate. For example, it is well known that productivity and corporate profitability rise rapidly as an economy comes out of a recession or a slow-growth period, simply because of efficiency gains as slack is reduced.

Getting back to a structural factor, technological change is rightly considered to play a significant role in enhancing productivity and the economy’s growth potential. This was indeed the case for the US economy in the nineties. There were, of course, other positive factors involved too, and it is notable that few people figured out the changes underway until they were well and truly in place. In the early 1990s, the US economy was generally looked upon as a potential underachiever.

There were certain characteristics of technological changes occurring in the 1990s that made them particularly potent in terms of enhancing productivity growth. The rapid propagation of the use of personal computers in virtually all businesses facilitated the execution of a variety of tasks and, via local area networks, made cooperation among workers easier.

Processing power increased rapidly, even as computer prices fell, making it relatively cheap for firms to upgrade equipment. In addition, the adoption of open standards allowed applications to run on a large number of different systems provided by diverse vendors. This was highly beneficial to end-users.

Meanwhile, the fast growth of the Internet constituted a revolution in speeding up communication and interaction as well as facilitating transactions. In this regard, the deregulation of telecommunications markets increased competition in the provision of bandwidth and internet access.

The more people were connected to the Internet the more valuable it became and induced even greater usage.

The Internet led to greater efficiency and resource allocation. It created transparency in markets, thereby intensifying price competition. People could easily check and compare posted prices. Trading assets and doing financial transactions online took a giant leap forward. Information on employment opportunities and job postings became readily accessible. The term e-commerce was invented to describe the institution of an open electronic market with extensive geographical reach.

Taking all the above factors together we can see that there were some major innovations going on with a positive impact on productivity and potential economic growth. A virtuous technological and productivity cycle was in place.

The recession in 2001 led to a sharp reduction in high-tech capital spending. It has rebounded since then, but still hasn’t recovered to the levels prevalent during the tech-boom period.

The current reality is that there are no “killer applications”, to use industry phraseology. No major innovations or a bunching of innovations, to generate another virtuous cycle. The diffusion from the previous bunch of innovations is probably largely spent out.

So, current technological change is mainly in the form of accretions and improvements rather than radical transformations.

As an indication of productivity improvement in the tech sector itself, as opposed to the benefits it brings to end-users, the price index for high-tech equipment that was falling rapidly in the nineties is now declining at a much more modest pace. Substantial quality-adjusted price cuts for new equipment provided an incentive for end-users to upgrade frequently. There is less motivation to do that now.

As mentioned above, there are other important factors in the productivity story and we will have to look at those in the future.

Iraj Pouyandeh is a Strategist and Senior Portfolio Manager at LOM Asset Management. He manages the LOM Global Equity Fund. For more information on LOM Asset Management please visit www.lomam.com