Non-farm productivity increases in Q1
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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 is 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 is 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 it is real (inflation-adjusted) interest rates that matter to the economy, not nominal ones. 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 they want to do. They would much prefer to have inflation running around 2% in order to achieve as close to negative real interest rates as they can achieve.
Highlights of the report
Productivity increased at a 0.7% annualized rate for the first quarter of 2013, as output increased 2.5% and hours worked increased 1.8%. This is an increase from the fourth quarter of 2012 (where productivity was -1.7%) and the first quarter last year (which was -0.7%). Manufacturing productivity increased 3.8% in the first quarter as output increased 5.6%; hours rose 1.7%.
Unit labor costs increased 0.5% in Q1, as compensation increased faster than productivity. Unit labor costs have risen 0.6% in total over the past year. Manufacturing saw the biggest increases in unit labor costs as hourly compensation increased at least 3%.
Implications for mortgage REITs
The increase in productivity means the Fed is feeling no inflationary pressures which would induce them 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 1/2 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 Walter (WAC), 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 do not. 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.