Productivity and ULC Ease Fed Inflation Concerns

Great news for the Fed on productivity and unit labor costs for the third quarter of 2007. The revisions showed productivity being revised even higher than expected to +6.3% annualized (consensus 5.9%, prior estimate 4.9%), after the GDP estimate was revised higher earlier, and unit labor costs being revised down to -2% annualized. Third quarter GDP unexpectedly increased at the fastest pace in four years in the third quarter, at 4.9% annualized. Output was revised higher to 5.7% annualized from the preliminary estimate of 4.3%.

Third quarter productivity, at 6.3% annualized, is at the highest figure since the 10.4% annualized gain achieved in the third quarter of 2003, and a substantial improvement from the 2.2% growth pace of the second quarter. Productivity at non-financial companies doubled to 4.2% in the third quarter, annualized, from 2.1% in the second quarter. Manufacturing productivity also doubled from the prior quarter, increasing by 5% annualized versus 2.4%. Rising productivity indicates rising worker efficiency, and reduces inflationary pressures. Productivity gains peaked in 2002, and have been trending lower since then. But over the last four quarters, productivity rose 2.7%, after rising just 1% for all of 2006, creating some hope that productivity gains are on the upswing again.

Unit labor costs (ULC) fell even more than expected, declining -2% annualized in the third quarter versus the initial estimate of a -.2% decline and a revised consensus call for a -1.2% drop. This marks the first two quarter consecutive decline in ULC since before my data begins in 1992. Otherwise, this was the largest quarterly drop in ULC since the third quarter of 2003, when it fell -4.5% annualized. Lower labor costs also reduce inflationary pressures. Unit labor costs appear to have peaked in the first quarter at 4.3% YoY, and has now fallen to 3% YoY in the most recent quarter, making the trend in labor costs look much more benign.

Compensation in the third quarter improved, rising +4.2% annualized(down from an original estimate of 4.7%) versus the 1% growth rate of the prior quarter(originally reported as +4.4% annualized). But, the number of hours worked fell -0.6% annualized. This caused real compensation, after inflation, to rise at 2.3% pace, down from the 2.7% annualized gain of the second quarter. Over the past year, nominal compensation per hour has risen 5.8% YoY, but at only 3.3% YoY when adjusted for inflation.

Unfortunately, the third quarter improvements in GDP output, productivity and ULC are not expected to be repeated soon. Fourth quarter GDP growth is now estimated to come in at only +0.1% annualized, a precipitous fall from the third quarter's rapid 4.9% annualized pace, as the economy slows. A rising percentage of economists and consumers are now looking for a recession.