US: Productivity and Costs

Highlights

U.S. nonfarm productivity growth was higher than expected in the second quarter, when it accelerated to an annualized rate of 1.4 percent, twice as much as the consensus of 0.7 percent. Un upward revision to the first quarter estimate from 0.3 percent to 0.8 percent added strength to the productivity data.

Unit labor cost growth meanwhile remained steady at 1.3 percent, below expectations of 2.2 percent in an Econoday survey, with hourly compensation up 2.7 percent. The previous quarter estimate for ULC was revised down from 1.8 percent to 1.3 percent.

Driving up productivity, output increased 1.7 percent in the second quarter after 1.5 percent in the first quarter, outpacing the 0.3 percent increase in hours worked, which slowed from 0.7 percent.

In its July 29 policy statement after leaving the policy rate unchanged, the FOMC qualified productivity and capital investment as"strong". While highlighting large AI investments, Chair Kevin Warsh said"More generally, capex is preparing the ground for future growth." He stopped short of specifying the expected impact on policy, noting that"the precise timing and magnitude of effects on the supply side remain hard to predict."

Market Consensus Before Announcement

Productivity growth rate expected at 0.7 percent in Q2 from 0.3 percent in Q1, rather disappointing gains. Unit labor costs are seen rising at a modest 2.2 percent rate versus 1.8 percent in Q1.

Definition

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.

Description

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.

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