A bolder blend: The forces behind stronger productivity growth

Summary

Productivity growth has taken on increased importance at a time when labor force growth is stumbling. Not only is it a determinant of the economy's potential rate of growth, but it also helps absorb higher input costs and serves as the key driver of real per capita income growth.

Productivity growth tends to vacillate from one quarter to the next. But, through its recent ups and downs, productivity growth has firmed this cycle, averaging an annualized rate of 1.8% compared to 1.5% in the prior economic cycle. What's behind the uptrend, and can it be sustained?

Labor productivity, or output per hour worked, can be broken down into three components: the composition of labor, capital input and total factor productivity (TFP). The contribution to productivity growth stemming from labor quality and capital investment has changed minimally this cycle. That leaves TFP, which can be viewed as productivity derived from new technology and processes, as the differentiating factor.

The drivers of TFP can be difficult to pinpoint in real time since it is measured as the residual of productivity gains not directly accounted for by hours worked and the capital stock. The jury is still out on any lift to productivity growth from remote work, although increased dynamism in the economy—evidenced by greater rates of business formation and job-switching—has likely provided a boost in recent years. Tight labor market conditions through this cycle also have helped spur the adoption of leading-edge technologies, giving workers better—not just more—capital at their disposal.

The advent of generative AI leads us to expect TFP and labor productivity growth more broadly to improve further this cycle. While the commercial use of genAI is still in its early days, its technological promise is bolstering the capital contribution to labor productivity while its potential speed of adoption could soon move the dial on TFP growth more discernibly.

That said, recent economic policies provide cross-currents to the productivity outlook. A lighter regulatory environment should help businesses to focus more on their core operations. Yet, in the near term, the fluidity of trade policy stands to do the opposite, and higher trade barriers could discourage future efforts to enhance efficiencies. Meantime, the sharp slowdown in low-skill immigration could incite stronger capital investment, but the current environment may also deter high-skill immigration, which historically has been an out-sized source of technological innovation.

The Congressional Budget Office projects nonfarm labor productivity growth to settle at an annual rate of 1.5% by 2030, essentially in-line with its 2010s average. We are more optimistic, and expect productivity to run closer to, if not slightly higher than, its historic trend of 2.1%. The firmer trend in productivity stands to counteract slower growth in the labor force and still keep the U.S. economy's potential rate of growth higher than it was in the cycle preceding the pandemic.

Download The Full Special Commentary