John Lynch Chief Investment Strategist, LPL Financial
Productivity for the third quarter of 2017 rose 3.0%, the largest one quarter increase since the third quarter of 2014 and over double the average quarterly growth rate since the start of 2009. This surge is significant, as a lack of productivity growth has been one of the main factors that has kept U.S. economic growth, as measured in gross domestic product (GDP), to an average of just 2.2% since the end of the Great Recession. In fact, the five-year average of productivity growth has been under 1% since the fourth quarter of 2014. Dating back to the start of record keeping in 1947, 1981 to 1983 was the only other period with productivity growth as slow. While productivity can fluctuate quite a bit from quarter to quarter, supporting evidence from increased spending on capital goods and the slow continued unwinding of labor disruptions from the Great Recession lead us to believe that a return to a healthier rate of productivity growth may be here to stay.
We’re Still Early in The Process
Productivity is impacted by a lot of factors and can change quite a bit from quarter to quarter, so it’s hard to place much stock in any one quarter. Part of the quarter’s growth may have been an offset for weakness in prior quarters, as even with the strong third quarter, year-over-year productivity growth remained modest at 1.5% and the five-year average only sits at an annual growth rate of 0.8%. Nevertheless, both numbers are the best since the second quarter of 2015.
Of greater concern, manufacturing productivity collapsed during the quarter, falling 5%, the worst level, excluding the Great Recession, since the U.S. Bureau of Labor Statistics started tracking the data in 1987. Both the general growth in productivity and the decline in manufacturing may have been affected by Hurricanes Irma and Harvey. The hurricanes may have caused more serious disruptions in less productive industries, such as food services, skewing the overall number somewhat higher. But within manufacturing, the hurricanes may have left equipment sitting idle, causing manufacturing in general to look artificially weak.
Nevertheless, the strong number for the quarter is a move in the right direction. The recent rebound in shipments of non-defense capital goods excluding aircraft and strong growth in private investment in equipment in the last two GDP reports (over 8% annualized real growth in both the second and third quarter of 2017) are a strong sign that businesses are increasing investment in productivity and the recent pickup may have staying power.
Why Labor Productivity Matters
If economic growth is going to increase, you either need more hours of labor (from more people working or people working longer hours) or more stuff produced per hour worked. There’s simply no other way to do it. The basic formula for productivity is the change in the amount of goods and services produced (the “product” of GDP) per hour of labor. More important than economic growth alone, productivity is the part of economic growth that flows through to improved standards of living. An economy will grow if more people work more total hours, assuming productivity stays constant, but standards of living will remain largely the same. Growth is simply a reflection of a larger labor pool. But if productivity picks up, the value of an hour of work rises, which can often be accompanied by organic increases in wage growth.
The recent third quarter provides a nice example. During the quarter, each person added 3% more value for each hour worked. At the same time, compensation for an hour of labor rose 3.5%. That 3.5% increase absent productivity increases would be tough for companies to carry. But if you look at what it cost to create an additional dollar of GDP, the costs only rose 0.5% since much of the increased cost was offset by the rise in productivity. Looking back over the last four quarters, hourly compensation rose by 1.4%, but productivity rose by 1.5%, which means additional productivity more than offset increased compensation. Because productivity growth has been low, the growth in unit labor costs has actually been fairly high despite slow wage growth. Improved productivity would help contain those costs even if wages started to rise more quickly.
Over the long run, productivity growth and wage growth should generally stay in line with each other, keeping the labor share of income fairly constant. In fact, the labor share of income declined sharply beginning in 2001 as productivity started to decline, and a reversal in productivity may also move the labor share of income back toward historical norms.