Dealers Nostalgic for U.S. Productivity Miracle

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May 2nd, 2012

In the fourth quarter of 2011, nonfarm business productivity grew at an annual rate of 0.9%, half its rate in the prior quarter. For all of 2011, the 0.4% increase in nonfarm business productivity was the smallest annual gain in the series since a 0.4% gain in 1995. At the same time, real hourly compensation decreased 0.7%, the largest annual decline in the measure since a 1.7% decline in 1989. In the preliminary Q1’12 release due May 3, economists representing every U.S. primary securities dealer expect nonfarm labor productivity to have fallen for the first time since Q2 of last year, with several dealers looking for the largest decline in more than three years. Consequently they expect unit labor costs to remain elevated, if not rise above the Q4 rate of 2.8% or the 2011 average of 3.2%.

While proxy data are available for both output and hours worked, there is tremendous variation in dealer estimates on productivity. As well, the consensus from the Reuters U.S. weekly poll calls for a drop in productivity of 0.5%, the median estimate among primary dealers is appreciably lower at -0.9%. The median estimate for ULC is 2.8% whether in the aggregate or for the subset of primary dealers.

 

In building its Q1 productivity forecast of -1.1%, Bank of America Merrill Lynch expected output in the nonfarm business sector (e: +2.6%) to have slightly outpaced the reported 2.2% rise in headline GDP growth for Q1 but felt “Hours likely grew at a quicker 3.7% pace as the labor market showed stronger signs of life in the first three months of this year. With real hourly compensation likely expanding about 1.9% in Q1, unit labor costs should rise 2.9% annualized in Q1, roughly matching the pace of increase in Q4 of last year. With wage growth still weak, most of the increase in ULC in recent quarters is a function of declining productivity. Companies are getting less at the margin with each new worker hired. With GDP underperforming aggregate hours, output per hour – productivity – is slowing. Since we are beyond peak rates of productivity growth and cost cutting, we have passed the peak rate of profit growth. In fact, one could argue that the recent weakness in employment is the first indication that the corporate sector is trying to rebuild productivity growth.”

Both J.P. Morgan Economic Research and RBS Securities estimate that nonfarm productivity declined 1.0% in the first quarter. Combined with their anticipated drop in productivity, JPM economists forecast ULC to be up 2.2% during the quarter “but other, less volatile, measures of compensation costs have been softer lately.” Following productivity growth of just 0.3% from Q4’10 to Q4’11, economists at RBS feel that a larger Q1 drop will be a continuation of “the anemic performance exhibited during all of 2011. This slowdown has been attributed to payback after unusually rapid productivity growth early in the recovery, as firms can no longer rely on efficiency gains to boost output. Slower productivity growth has also helped to explain the disparity between moderate GDP growth and rapid declines in the unemployment rate.” RBS expects unit labor costs in Q1 “could have risen at a 3.5% annualized clip”, above both the Q4’11 increase (2.8%) and the full-year 2011 average advance (3.2%).

As Deutsche Bank Global Markets Research has pointed out several times, the length of the U.S. workweek has nearly returned to pre-recession levels, and the relative absence of deepening capital has left output per hour lower and ULC higher. DBGMR recently wrote, “Up to this point in the cycle employers were broadly able to extract additional output from their existing workforce by lengthening the workweek and thereby diminishing the need for additional workers. Employers must now increasingly depend to a larger degree on hiring in order to expand output. [Cost] pressures appear to be relatively muted at present, but they will only intensify as output continues to expand. The key point is that the aggregate income trend, which we are tracking so carefully, is likely to be less defined by hours growth in the coming quarters; instead, it will be increasingly driven by hiring gains and rising unit labor costs.”

 

Other developed economies are encountering a similar fading of the productivity miracle. Writing about the U.K.’s pre- and post-crisis experience, HSBC Securities questioned whether British firms were operating with ample amounts of spare capacity or if there has been a permanent reduction in productive capacity. HSBC economists wrote in late February, “We think that a mixture of flat real wages, forbearance by creditors and loose monetary policy has allowed firms to hoard labour. This means firms should have plenty of slack. But if demand remains weak – due to a combination of the fiscal consolidation, uncertainty and a household debt overhang – then slow productivity growth could persist. In turn, unemployment is likely to remain elevated and wage growth restrained. This could mean more QE later in the year to stoke demand.” They could just as easily be talking about the U.S. as the U.K. And regarding what policy makers deem to be trend productivity (about 2.2% per year in either the U.S. or U.K.), HSBC says, “It is possible that comparable growth rates will not be achievable in the post-crisis world.”

Spanning the last three business cycles, there is a decent correlation between unit labor costs and fed funds. As the chart suggests, the recent run-up in ULC would otherwise bring expectations of increases in administered interest rates. No dealers are prepared to call for Fed policy action today given the circumstances in domestic and global economies. Nevertheless, advances in ULC have probably gained the attention of some Fed officials.

No matter how negative they think the May 3 result will be, all primary securities dealers captured in the latest Reuters poll believe U.S. nonfarm business productivity in the U.S. declined some in Q1. Few dealers see the falling trend in productivity growth reversing any time soon.

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