Manufacturing slows, but still grows

The August ISM manufacturing index slipped a little, but was nevertheless somewhat stronger than expectations (50.6 vs. 48.5). As the chart above shows, at this level the index is consistent with overall GDP growth of about 2%. For most of the recovery to date, the manufacturing sector has been the star performer, but now it too has slowed down, along with the rest of the economy.

But this does not mean we are on the cusp of another recession. The economy has been fighting numerous headwinds this year (e.g., the Japanese tsunami, bad weather, increased regulatory burdens, and the threat of a Eurozone banking system collapse), so forward progress has been slow. However, it's my belief that growth and expansion are the natural state of affairs when it comes to the U.S. economy. It takes an awful lot to stop it or to drag it down to recessionary levels. Left to its own devices, the economy will expand by roughly 3% a year. Given the proper incentives, and given the unusually large amount of idle resources present these days, the economy could easily enjoy 5-6% growth for several years. That the economy is not doing a lot better is the problem, not that it risks slipping into a recession. The notion that slow economic growth is like "stall speed" for an airplane—below which you abruptly lose altitude—is terribly misleading; analogies are not always helpful aids to understanding.

The rather abrupt slowdown in growth this year is reflected in an equally abrupt decline in productivity. After rising at an almost 4% annual rate in the two years ending last December, productivity plunged to -0.7% in the first half of this year. This in turn has meant a sharp increase in unit labor costs, as shown in the chart above. A highly productive labor force contributed to low inflation through the end of last year, but now, weak productivity is contributing to higher inflation via higher unit labor costs. But as the chart also suggests, all of this is fairly typical in the early years of a business cycle expansion, so it is not deeply troubling. Recessions oblige business to drive down costs and increase worker productivity, and most of those gains have now been realized. Going forward, growth will be more a function of new hiring, rather than getting more out of the existing workforce.