Improving GDP aids productivity

The improvement in GDP from Q2 to Q3 helped to lift nonfarm productivity in Q3 by an annual rate of 1.9%, that’s up from a -1.8% in Q2.  The increase comes as output rose by 3.0% while hours were were up just 1.9%.


The improvement in productivity resulted in a 0.1% decline in unit labor costs, as productivity grew 1.9% while hourly compensation increased 1.8%.


As chart 1 from the BLS reveals, rising output, without the accompanying increase in hours worked (job growth) has had a very favorable impact on productivity growth.  This is normal during the early stages of an economic recovery since employers are reluctant to boost hiring amid worries that improving conditions may be temporary.

This time around, the uncertainty swirling around the economy has exacerbated the conditions that have led to a lack of employment growth.

Data give Fed room to maneuver
Rising productivity and the lack of meaningful wage gains have kept unit labor costs well under control – see chart 2.  The absence of higher unit labor costs, coupled with weak overall demand, has kept inflation very low, giving the Fed plenty of wiggle room to embark on its latest round of bond buys.

However, the Fed must carefully plan its eventual exit strategy.  Too soon of a withdrawal of the extra liquidity could send the economy into a tailspin.  Wait too long and the U.S. economy experiences high inflation.

Productivity continues to leap ahead

Productivity is one of those statistics that few really get excited about, unless one is either an economist or someone who has spent plenty of time studying the field of economics.  Despite the apparent lack of interest, let’s take a stab at it.

This morning the government reported that 4Q nonfarm productivity surged at an annual rate of 6.9%, well ahead of the initial estimate of 6.2%.  This came about as output  grew by 7.6% and hours worked rose 0.6%.  A quick review of the math, and some rounding, gives us the 6.9 figure.

Given the huge jump in productivity and the small increases workers are receiving in compensation, it comes as no surprise that unit labor costs plunged 5.9%, faster than the originally-reported drop of 4.4%.

As I’ve already mentioned, few get excited about this release, but changes in productivity and unit labor costs impact all of us.

Typically, productivity surges in the early stages of an economic recovery because companies start to ramp up output without adding staff.  Needless to say, this recovery is no exception!

But as companies start to increase hiring, productivity increases level off.

So why is all of this important? 

Strong gains in productivity over time enable companies to increase wages and benefits without adding to inflation. And rising compensation without an accompanying increase in inflation raises living standards.

However, during the initial phase of an economic recovery, the jump in productivity has its downside – a jobless recovery.

A  second important component of this report is unit labor costs.  Wages and benefits are the largest single cost for most companies.  If higher productivity mitigates increased salary expenses, inflation is much less likely to get entrenched during an economic cycle.

Looking at what is going on today, we are seeing plenty of excess capacity and small increases in overall demand, making it very difficult for businesses to raise prices.  Moreover, unit labor costs are falling, which helps corporate profits and dramatically lessens the need for price hikes.

In this environment, inflation simply is not a threat at the present time, allowing Federal Reserve officials to focus on the dreadful employment picture and not inflation. 

Down the road, the Fed will be faced with the delicate task of raising interest rates and nipping any potential inflation threat in the bud.

Productivity soars

Led by a 13.6% rise in manufacturing productivity, the largest since the series began back in 1987, nonfarm business productivity soared at an annualized rate of 9.5% in 3Q, according to preliminary data. Unit labor costs, which are heavily influenced by productivity, fell a steep 5.2% in 3Q.

Forecasts provided by Bloomberg News called for a 6.3% increase in productivity and a 3.9% decline in unit labor costs.

Notably, unit labor costs declined 3.6% over the last four quarters—the largest decrease since the series began in 1948, according to the government. With labor costs, which are the largest piece of the expense equation for most businesses, well under control, the risk of an unwanted rise in inflation is highly unlikely.

No real surprises despite the big miss by forecasters

Huge gains in productivity and corresponding declines in unit labor costs are to be expected in the early stages of an economic recovery because firms are reluctant to add new workers even as production pick up. And in this case, the continuation in job losses added to the out-sized increases in productivity.

As layoffs wind down and hiring picks up (as many analysts anticipate will eventually occur), productivity gains will eventually begin to slow.

Productivity, labor costs, unemployment and inflation

Productivity jumped in 2Q because businesses continued to reduce hours (-7.6), but cutbacks in output slowed dramatically (-1.7). Normally, productivity surges during  the end of a recession and the early stages of a recovery because businesses are reluctant to add workers as output grows.

With the exception of just a 0.1% dip in 1Q and 3Q of 2008, productivity remained positive despite the severity of the recession, highlighting how quickly companies shed workers in the face of falling demand.

The drop in unit labor costs is the direct result of the sharp gains in productivity, which could ease some of the rising cost pressures from increases in commodity prices and gasoline.

Core inflation fell through much of the 1990s amid rising productivity and flat commodity prices. Following the mild slump of 2001, inflation did not bottom until late 2003. 

The core CPI has been stuck near the high end of the Fed’s implied target of 1-2%.  With expectations of a recovery later in the year and a bounce in commodity prices, worries that inflation could fall to undesirably low levels was not present in the last FOMC statement that accompanied the interest rate decision in June.

Outsized gains in productivity and excess capacity around the world, however, may put downward pressure on inflation going forward, offsetting some of the impact of rising commodity prices and the still-accommodative monetary policy.

A more conventional viewpoint is available at Examiner.com.

Productivity, unit labor costs or why inflation is sticky

It turns out that nonfarm productivity advanced at an annual rate of 1.6% in 1Q. That compares favorably to the initial report of a 0.8% rise and the forecast per Bloomberg News of 1.2%. Productivity has gradually trended lower because businesses have not been able to reduce hours worked as quickly as cutting back on output.

In 1Q, output tumbled by 7.6%, and hours worked fell 9.0%, the fastest pace in over 30 years. Do the math and you come up with 1.6%.

Let’s look at unit labor costs. Unit labor costs rose at an annual rate of 3.0% in 1Q as hourly compensation increased by 4.6%. Again, it’s simple arithmetic. 4.6 minus 1.6 (productivity) brings us to 3.0.

For many businesses, labor is the most expensive input. In good economic times, companies may find it difficult to find qualified employees and will bid up salaries in order to retain and acquire good workers. The pinch to the profit margin is usually resolved by raising prices. And when demand is strong, firms are typically able to make price increases stick.

So what’s going on? Business is terrible but unit labor costs are in a gradual upward trend. Companies may be shedding employees at a near record pace (remember, hours factor into productivity), but they apparently are not cutting back so quickly as to significantly boost productivity and bring down unit labor costs.

The apparent result, coupled with the lingering effect of last year’s surge in commodity prices, is a rate of core inflation, prices less food and energy, that is holding up near the top end of the Fed’s implied range of 1-2%.