Q1 Productivity & Wages: Still Below Trend

We still have below trend labor productivity, and the labor share remains weak. Productivity and inflation expectations kept wage growth elevated.

Today's release of the BLS's preliminary "Productivity and Costs" report for Q1 saw a weak quarter/quarter labor productivity growth. As this is a very noisy, volatile series any interpretation should be done carefully. On the other hand, the labor share went up on a quarterly basis. What is more relevant is the medium-term trends in these series. Additionally, these trend estimates can be used to interpret recent wage growth, such as, for example, for the Fed’s favorite wage growth gauge, the private sector wage component of the Employment Cost Index (ECI), for Q1 that was released earlier this week. This note looks at the above in a bit more detail.

Key takeaways:

• Over the quarter labor productivity was weak in Q1, and labor productivity stalled below its trend estimate. Base effects resulted in an acceleration in year/year growth.

• The pace of trend labor productivity growth, which was 1.3% year/year in Q1, remains below an average trend labor productivity growth rate of 1.9% year/year in 2019.

• The labor share went up over the quarter and caught up with its trend estimate, which is estimated to be -0.7% year/year in Q1 compared to an on average flat trend labor share estimate for 2019.

• The Q1 ECI index for wages of private sector workers went up 4.3% year/year. This is about 1.6 percentage point above the wage growth rate consistent with 2% inflation given the trend growth rates of labor productivity and the labor share.

• The Q1 overshoot in ECI wages of private sector workers was driven by above trend year/year labor productivity growth, mostly owing to base effects, and still relatively elevated near-term inflation expectations of firms and households.

Labor Productivity

Labor productivity for the non-farm business sector only grew 0.3% quarter/quarter AR year/year in Q1, after increasing 3.5% in Q4. On an annual basis labor productivity growth accelerated from 2.7% year/year to 2.9% in Q1, which is due to base effects as between Q2 2023 and Q1 2021 labor productivity dropped throughout most of that period. However, how does this compare to its underlying longer-term trend?

Without wanting to resort to some structural model, I base my estimate of trend productivity on a number of different purely statistical approaches as outlined here and use an average of the estimates from these approaches as the trend labor productivity estimate. As such this average reflects the uncertainty with respect to the 'true' trend level of labor productivity.

This estimate of trend labor productivity is plotted in the chart above (orange line), and it suggests a slight slowdown in trend labor productivity during and after the pandemic compared to the pre-pandemic period. For example, trend labor productivity increased 1.3% year/year in Q1, respectively, which trails the average trend labor productivity growth rate of 1.9% year/year for 2019.

Comparing actual labor productivity with my trend estimate suggests that after a long period of declines labor productivity turned a corner in Q2 2023 and started to converge back to trend. However, the data for Q1 suggests that the convergence back to trend stalled and might even have fallen back slightly. The above-trend labor productivity growth rates in Q3 and Q4 likely reflected a catch-up dynamic rather than accelerated trend labor productivity growth, but it is unclear whether this will continue in 2024. For now, I still expect the convergence back to trend to reemerge after Q1, but if not the recent favorable impact of elevated productivity growth on prices and wages will become a non-factor in 2024.

The Labor Share

The labor share represents the compensation firms pay their workers as a share of the firms’ revenues. This measure is useful to have alongside labor productivity data, as higher labor productivity in principle should result in higher real wages but the extent to which this happens depends on this labor share.

In Q1 the labor share for the non-farm business sector improved notably on a quarter/quarter basis, from -1.2% quarter/quarter AR to +1.8% in Q1. On an annual basis Q1 labor share growth was about -0.3% year/year vs. flat in Q4. As was the case for labor productivity discussed earlier, I use an average across different purely statistical approaches (outlined here) to pin down the trend labor share.

The orange line in the chart above depicts the trend component of the labor share. Throughout 2016-2019 this trend labor share was stable, but it has been on a declining trajectory since 2020. For example, trend labor share growth in Q1 was about -0.7% year/year but it was on average flat throughout 2019.

Q4 Wage Growth: Interpreting the Recent ECI Moves

The Employment Cost Index (ECI) is seen as the Fed’s favorite gauge of labor compensation growth, as it corrects for any compositional shifts across sectors (much like the Atlanta Fed Wage Growth Tracker). The Q1 ECI report was published on April 30th. The most important measure from this report is the ECI for wages of private sector workers (ECIWP), stripping out non-wage labor compensation as well as public sector wages. ECIWP was up 4.3% year/year in Q1, about the same as in Q4.

Much in the same way I do for monthly wage measures, one can use the trend estimates for labor productivity and the labor share outlined above to get a trend wage growth estimate consistent with the Fed’s 2% inflation target. This simply equates to 2% plus the year/year growth rates implied by the earlier discussed trend estimates of labor productivity and the labor share.

The chart above contrasts this trend wage growth measure with actual ECIWP wage growth, and it is notable that in recent years actual wage growth overshot this trend value. More specifically, for Q1 ECIWP wage growth equal to 4.3% year/year was about 1.6 percentage point above the rate of growth that would be consistent with 2% inflation.

So, what drove the recent overshooting of wage growth compared to the pace consistent with 2% inflation? To do that I decompose the gap between actual ECIWP wage growth and its 2% inflation consistent trend using the deviations of actual year/year growth relative to estimated trend growth for both labor productivity and the labor share, the gap between year-ahead inflation expectations of firms and households compared to the 2% inflation target, and an unexplained residual. The “Main Street” inflation expectations are extracted as the common trend across a number of surveys, as I described in an earlier post.

Since my “Wages and Inflation Expectations - April 2024 Update” note, I have incorporated the release of April year-ahead expectations from the Conference Board’s Consumer Confidence survey from earlier this week as well as last week’s final release of the April University of Michigan Consumer Survey in this inflation expectations aggregate. The aforementioned year-ahead “Main Street” expectations eased since late 2023 to about 2.6% in terms of year/year PCE inflation for Q1 2024 but picked up somewhat to 2.7% in April (chart above).

The chart above shows that, not surprisingly, during and right after the COVID lockdowns the ECIWP gap relative to the inflation target-based trend was heavily affected by (often offsetting) large swings in labor productivity and labor share gaps. Since mid-2021 the ECIWP wage growth gap has been persistently positive (above a pace consistent with 2% over the medium term), as the inflation expectations gap turned positive in a sizeable way. However, throughout 2023 the impact of above-trend inflation expectations declined whereas the impact of above-trend labor productivity gained in importance.

Focusing on Q1 in the chart above, the inflation expectations gap equaled +0.6 percentage point, down from +0.9 percentage point in Q4, whereas the labor productivity growth gap contribution increased from +1.4 percentage point to +1.6 percentage point in Q1. The labor share gap contribution flipped declined +0.6 percentage point in Q1 to +0.4 percentage point.

So, the Q1 ECI wage overshoot relative to the inflation target trend was largely driven by above trend year/year labor productivity growth and, to a lesser degree, above-target near-term inflation expectations. Note that the above trend year/year labor productivity growth rate mainly reflects base effects, as labor productivity was weak over the quarter.

Beyond Q1, “Main Street” inflation expectations as of April suggest that the inflation expectations gap could contribute somewhat more to ECI private wage growth in Q2 than in Q1. Also, year/year labor productivity growth beyond Q1 could slow down as base effects start to wane. Thus, going into 2024 Q2 and beyond, we could have more easing in the ECI wage growth for private sector workers, but inflation expectations of firms and household likely will keep it above inflation target-consistent pace.