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U.S. Productivity Advances Solidly

Prof. Peter Morici - 3/14/2007

Tuesday, the Department of Labor reported productivity in the nonfarm private business sector increased at a 1.6 percent annual rate in the fourth quarter of 2006. This was a sharp improvement over the 0.5 percent decline recorded in the third quarter.

Average productivity for all of 2006 was up 1.6 percent over 2005.

This solid performance indicates the growth potential of the U.S. economy remains significant.

Hourly compensation increased 8.2 percent in fourth quarter, and unit labor costs, which factors in higher wages and higher productivity, rose 6.6 percent. On an annual basis, hourly compensation and unit labor costs increased 4.8 and 3.2 percent, respectively.

On the one hand, stronger wage growth should shore up consumer spending and GDP growth the first half of 2006, however, it does explain some of the inflationary pressures recorded the second half of 2006. Workers were able to recoup real income lost to high energy prices.

Recent inflationary pressures in labor markets have resulted, most importantly, from a mismatch between the skills required by business and those offered by available workers, as opposed to a general shortage of labor. That problem should ease in the months ahead, especially with GDP growing at only about 2.5 percent during the first half.

Outlook for Productivity Growth

The slowdown in productivity growth recorded in the third quarter was likely attributable to the adjustments in capacity utilization and investment imposed by the housing slowdown and jump in energy prices. Those were temporary events, and productivity growth should be strong in the months ahead but especially in the second half of 2007

The U.S. economy continues to bang out new products and more efficient methods for making goods and services. Little good evidence has been offered to explain why the process of accelerated innovation that began in the 1990s should dissipate now. Productivity will continue to surge in the months ahead. Coupled with a one percent annual growth in the labor force, the economy can grow 3 percent a year with the right mix of fiscal and monetary policies.

The overvalued dollar takes constrains productivity gains, because the resulting trade deficit shifts labor and capital from export and import-competing industries into other non-trade- competing activities. The trade deficits shifts the production of new and innovative products offshore, reducing high-value employment immediately and increasingly the likelihood that next generation products will developed as well as made abroad.

Trade-competing industries exhibit 50 percent higher labor productivity and spend much more on R&D than do the rest of the economy. Cutting the trade deficit in half would boost R&D spending enough to push sustainable productivity growth to about 3 percent per year, and raise potential GDP growth to about 4 percent.

Outlook for the Stock Market

Good productivity growth is good news for the stock market, because it indicates profit margins can be sustained.

Stronger productivity growth fuels corporate profits by permitting U.S. businesses to maintain or widen margins on domestic operations. Also, U.S. businesses are taking their innovations abroad, and foreign operations account for significant shares of U.S. corporate sales and profits. Overall, corporate profits in 2007 will be better than expected, and the stock market should soon regain its footing.

The recent shocks from Asia will pass, and U.S. stocks will regain lost ground and finish up in 2007.

Overall, steady interest rates, productivity gains and new products, and profits from overseas operations should help the stock market recover lost ground and will give new legs to the bull market.