Q1 contraction obscures the view: Productivity growth still solid

Summary

Nonfarm labor productivity contracted at a 0.8% annualized rate in Q1. While eyecatching, productivity is noisy quarter-to-quarter, particularly given the trade-induced negative GDP growth print in Q1. When smoothing through recent choppiness, the underlying trend in labor productivity growth remains firm. Consequently, the underlying increase in unit labor costs is consistent with inflation eventually returning to the Federal Reserve's 2% inflation target. That said, risk lies ahead. Slow growth in the labor supply could exert upward pressure on labor costs even as demand for workers eases, and tariffs pose some downside risk to productivity.

Productivity slides into the red

Nonfarm labor productivity hit an air pocket. Output per hour worked contracted at a 0.8% annualized rate in the first quarter, marking the first decline since 2022 (chart). The slip was driven by a mix of faltering output growth and stable employment growth in the first three months of the year. While eye-catching, productivity is noisy quarter-to-quarter, and this past quarter felt noisier than most. As discussed in our GDP write-up, tariff front-running led to a historic import surge that obscured still-solid domestic demand growth in the first quarter. Looking through the recent choppiness, labor productivity is up 1.4% relative to a year ago.

Strong productivity growth has played a key role in easing the labor market's inflationary impulse over the past year or so. When employees produce more per hour worked, total output increases while total labor compensation cost stays the same. Employers can thus enjoy greater profits and have more flexibility to absorb higher costs without needing to raise selling prices. Since the pandemic, nonfarm labor productivity has averaged 1.8% annual growth, slower than the 1990s (2.1%) and early 2000s (2.8%), but stronger than the business cycle preceding the pandemic (1.5%).

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