Nonfarm productivity was up at an annualized rate of 3.0 percent in the fourth quarter after rising 1.4 percent in the third quarter (revised up from 0.8 percent), topping expectations in an Econoday survey that ranged from 0.5 percent to 2.7 percent. The last time productivity gains were this high was in the fourth quarter of 2021. Unit labor costs rose 1.1 percent after 2.0 percent the previous quarter (revised from 2.4 percent), the smallest increase since they declined 4.2 percent in the first quarter of 2021. Econoday's consensus estimate was 1.5 percent.

A 3.5 percent gain in output while hours worked were up just 0.5 percent explains the productivity gains in the fourth quarter. Output expanded 3.6 percent in the third quarter after contracting the previous two quarters.

The larger-than-expected productivity gains combined with a 4.1 percent increase in hourly compensation drove unit labor costs 1.1 percent higher in the fourth quarter. Unit labor cost growth consistently slowed in 2022, starting at 8.5 percent in the first quarter followed by gains of 6.7 percent and 2.0 percent in the two following quarters. After three consecutive quarters of declines, real compensation recovered 1.0 percent in the fourth quarter.

In the manufacturing sector, labor productivity didn't fare as well, as it declined 1.5 percent in the fourth quarter, with output contracting 2.6 percent and hours worked down 1.1 percent. Unit labor costs rose 4.8 percent.

For 2022 as a whole, nonfarm annual average productivity decreased 1.3 percent from 2021, the largest drop since 1974. Meanwhile, unit labor costs rose 5.7 percent, after 2.4 percent in 2021, representing that largest increase since 1982.

Nonfarm productivity is expected to rise to a 2.4 percent annualized rate in the fourth quarter versus growth of 0.8 percent in the third quarter. Unit labor costs, which rose 2.4 percent in the third quarter, are expected to rise to a 1.5 percent rate in the fourth quarter.

Productivity measures the growth of labor efficiency in producing the economy's goods and services. Unit labor costs reflect the labor costs of producing each unit of output. Both are followed as indicators of future inflationary trends.

Productivity growth is critical because it allows for higher wages and faster economic growth without inflationary consequences. In periods of robust economic growth, productivity ensures that inflation will remain well behaved despite tight labor markets. Productivity growth is also a key factor in helping to increase the overall wealth of an economy since real wage gains can be made when workers are more productive per hour.

Productivity and labor cost trends have varied over the decades. In the late 1990s, some economists asserted that dramatic productivity advances (based on new technologies) were then allowing the economy to sustain a much faster pace of growth than previously thought possible. Initially, some Fed officials expressed skepticism but later decided that productivity gains had helped boost economic growth and potential GDP growth during the 1990s. That is, the economy could grow faster than previously believed without igniting inflation.

Determining the source of productivity gains has become trickier over the last decade as new technology continues to be incorporated into production - not just in the U.S. but overseas also. Similarly, retraining U.S. workers has been sporadic. Not just low skill jobs are outsourced but now many highly skilled jobs such as programming and accounting are as well. Nonetheless, highly skilled professional jobs have been increasingly difficult to fill during times of high demand. Despite the cross currents in labor market trends, long-term productivity gains are important for maintaining growth in labor income and keeping inflation low.

But in the short-term, output and hours worked can shift sharply just due to cyclical swings in the economy. During the onset of recession, output typically falls before hours worked. This can result in a temporary drop in productivity and a spike in unit labor costs. So, while long-term productivity determines the"speed limit" for long-term growth, one should not be misled by short-term cyclical gyrations in productivity numbers as reflecting the true, underlying trend.