Q3 2024 Productivity & Wages: Still Recovering

Labor productivity remains just below trend, and the labor share is now showing above-trend growth. The latter is the main source of elevated wage growth.

Today's release of the BLS's preliminary "Productivity and Costs" report for Q3 saw a very slight pick-up in quarter/quarter labor productivity growth compared to Q2. As this is a very noisy, volatile series any interpretation should be done carefully. Growth of the labor share accelerated notably on a quarterly basis after it was essentially flat in Q2. 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 Q3 that was released last week. This note looks at the above in a bit more detail.

Key takeaways:

• Over the quarter labor productivity growth was solid in Q3, but the labor productivity level remains below its trend estimate. Base effects continued to drive an easing in the year/year growth rate.

• The pace of trend labor productivity growth, which was 1.5% year/year in Q3, remains below an average trend labor productivity growth rate of 2% year/year in 2019.

• The labor share grew at substantially higher pace over the quarter and now outpaces its trend estimate, which is estimated to have declined 0.8% year/year in Q3 compared to a close to flat trend labor share estimate for 2018.

• The Q3 ECI index for wages (excl. incentive pay) of private sector workers went up 3.8% year/year. This is about 1 percentage point above the trend wage growth rate consistent with 2% inflation given the trend growth rates of labor productivity and the labor share.

• The Q3 overshoot in ECI wages of private sector workers was mainly driven by above trend year/year labor share growth: workers are increasingly getting a larger share of business revenues relative to longer term trends. Above trend labor productivity growth and elevated near-term inflation expectations of firms and households contributed modestly to the overshoot as well.

Labor Productivity

Labor productivity for the non-farm business sector grew 2.2% quarter/quarter AR in Q3, after a downwardly revised 2.1% increase in Q2. On an annual basis labor productivity growth eased from 2.4% year/year to 2% in Q3. 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 1.5% year/year in Q3, which trails the average trend labor productivity growth rate of (an upwardly revised) 2% 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. The current above-trend labor productivity growth rates likely reflect a continued catch-up dynamic rather than accelerated trend labor productivity growth. However, today’s data release suggests that the pace of convergence back to trend peaked in Q1 2024 at 2.8% year/year and has since slowed. Given that the productivity gap relative to trend is closing, the favorable impact of temporarily elevated productivity growth on prices and wages rate is likely to fade in 2025.

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 Q3 the labor share for the non-farm business sector grew on a quarter/quarter basis, from +0.1% quarter/quarter AR to 1.6% in Q3. On an annual basis Q3 labor share growth was about 1.6% year/year vs. 0.9% in Q2. 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. Up to 2018 this trend labor share increased at a modest pace, but it has been on a declining trajectory since 2019 (in the previous vintage of data this decline did not set in until 2020). For example, trend labor share growth in Q3 was about -0.8% year/year but the year/year trend growth rate on average flat in 2018.

Q3 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 Q3 ECI report was published on October 31st. The most important measure from this report is the ECI for wages of private sector workers (ECIWP), stripping out non-wage labor compensation (i.e., incentive pay) as well as public sector wages. ECIWP was up 3.8% year/year in Q3, down from 4.1% in Q2.

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 recently actual wage growth overshot this trend value. More specifically, for Q3 ECIWP wage growth equal to 3.8% year/year was about 1 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.

I have incorporated the release of October year-ahead expectations from the Conference Board’s Consumer Confidence survey, the University of Michigan Consumer Survey and the Atlanta Fed Business Inflation Expectations Survey, as well as the September NY Fed Consumer Survey. The aforementioned year-ahead “Main Street” expectations increased in Q2 2024 to 2.69% in terms of year/year PCE inflation from 2.57% previously but eased to 2.53% in Q3 2024 and 2.57% in October (chart above).

The chart above shows that since mid-2021 the ECI private sector 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. Throughout 2023 and early 2024 the impact of above-trend inflation expectations declined whereas the impact of above-trend labor productivity gained in importance.

However, the most notable development in 2024 has been the rapid increase in the contribution of above trend labor share growth (blue bars in the chart above) to elevated wage growth. This is in line with the wage income revisions in the August PCE report and reflects a major revision from the previous vintage of data. In 2024, workers’ share of business revenues is increasingly outpacing longer-term trends, which has become the main driver behind elevated wage growth.

Focusing on Q3 in the chart above, the inflation expectations gap equaled +0.53 percentage point, down from +0.69 percentage point in Q3, whereas the labor productivity growth gap contribution decreased from +0.90 percentage point to +0.51 percentage point in Q3. The labor share gap contribution is really the component that increased notably in Q3 from +1.67 percentage point to +2.39 percentage point.

Beyond Q3, “Main Street” inflation expectations as of October suggest that the inflation expectations gap will likely contribute similarly to ECI private wage growth in Q4 as in Q3. Also, given that the gap between the current and trend levels of labor productivity is closing year/year labor productivity growth beyond Q3 could slow even more. Thus, going into 2024 Q4, inflation expectations of firms and household likely will keep it somewhat above inflation target-consistent pace. But, but if above-trend growth in workers’ share of business revenues persists inflation expectations could accelerate again in 2025.