The Holy Grail Remains Elusive

Every economist will tell you that labor productivity is one of the keys to sustainably higher growth rates in both the economy and living standards. The reason is fairly simple. When workers become more productive, it means they can produce more of a given product or service per hour worked. If they can produce more in the same amount of time, then their employers can afford to pay them a higher hourly wage. And as long as the wage increases are below the revenue gains achieved through higher unit sales and pricing, the employer will benefit from higher profit margins. All else equal, this scenario should lead to both solid wage gains for the worker as well as increased profits for the employer. Ideally, that employer could then reinvest the higher profits into growth initiatives, which could potentially include additional employees. This is the type of virtuous cycle that the Fed would love to see – productivity-driven wage increases, increased business investment, and job growth. And the beautiful feature of this type of growth is that inflation should remain relatively well-contained due to the supply gains associated with increased labor productivity.   

Unfortunately, the rapid gains in labor productivity we saw in the quarters immediately following COVID’s arrival are now reversing. This morning we learned that labor productivity fell 1.3% year-over-year in the third quarter after dropping in each of the first two quarters of the year (-0.4% in the 1Q and -2.1% in the 2Q). The Bureau of Labor Statistics also reported this morning that unit labor costs increased at a 5.3% annual rate in the third quarter after increasing 6.5% in the first quarter and 7.0% in the second quarter. If we add the changes in productivity to the changes in unit labor costs, we arrive at the change in hourly compensation (which is depicted by the black line in the chart below). The interpretation can be stated like this: employment costs for employers continue to increase fairly rapidly even though labor productivity is now falling. And given that inflation is running at rates well in excess of wage growth (ie, inflation-adjusted wage growth is negative), this is not a positive scenario for anyone. 

Though the drop in labor productivity this year may simply represent a reversion to the mean now that the COVID distortions are subsiding, the development is nonetheless bad news for the Federal Reserve and investors. The Federal Reserve will be concerned that the drop in productivity will be inflationary, especially given the low rate of unemployment and the rapid increase in wages over the past year-plus. Investors will be concerned that labor shortages continue to drive labor costs higher, even though worker productivity is now falling. Those increased labor costs are likely to cut into profit margins, leading to downward revisions to earnings estimates and potentially lower stock prices. 

Ideally, labor productivity gains will soon revert back to the average 1.8%-1.9% pace from the turn of the millennium through the 4Q19 (last quarter before COVID arrived). The resulting moderation in unit labor costs would alleviate inflationary pressures as well as pressures on corporate margins. Until then, though, labor productivity is a key metric that both investors and the Fed should be closely monitoring.