Productivity growth lifts inflation when demand outpaces capacity
A Bank of England working paper finds that productivity growth is not inherently disinflationary and can drive consumer prices higher. When firms and households anticipate future income gains, surging consumption and investment push up the natural interest rate before supply expands.
When wealth effects eclipse supply gains
Authors Ludovica Ambrosino, Jenny Chan, and Silvana Tenreyro model productivity shocks in an open economy New Keynesian framework.
While a one-off level shock lowers marginal costs and creates temporary disinflation, persistent productivity growth triggers substantial wealth effects.
Anticipating higher lifetime income and stronger returns, households increase current consumption while firms expand investment.
If aggregate demand strengthens before productive capacity materialises, the natural real interest rate rises.
Absent an offsetting monetary policy tightening by central banks, excess demand pushes consumer prices upward.
The paper shows that historical episodes such as the late 1990s technology boom demonstrated rising price pressures rather than permanent disinflation.
Tradables, exchange rates and spillovers
Sectoral composition also determines inflation outcomes.
Because tradable goods prices are anchored to international markets, productivity gains in domestic tradables raise wages and spill over into non-tradables demand, pushing consumer inflation higher.
Conversely, a gradual tradables expansion prompts rapid exchange rate appreciation, lowering import costs enough to produce disinflation.
The researchers conclude that monetary policymakers must track movements in the natural interest rate rather than assuming technology improvements automatically suppress inflation.
No free lunch from technology
Central banks too often view productivity gains as automatic disinflationary windfalls.
This paper correctly dismantles that assumption by showing how anticipation and shifting natural rates can fuel price pressures.
Policymakers must track spending surges rather than banking on effortless supply relief.
Source: Productivity and inflation dynamics
IN: