Tuesday, August 08, 2006

Revised and Updated Labor Costs Still Tame

Some people will look at the new second quarter figure for unit labor cost in this morning’s productivity report and conclude that labor costs have become an inflation problem. Unit labor cost was up at 4% annual rate in the second quarter and up 3.1% from the same quarter a year ago. As I’ve said before, though, this series is volatile, and the appropriate way to analyze it is to smooth the quarterly changes. Taking into account the revisions and the latest update, my smoothed series now looks like this:

It stands at 1.7%, still quite close to the 1.5% center of the assumed hypothetical target range. In fact, on the off chance that the Fed really is targeting unit labor costs, let me offer my personal congratulations to each of the FOMC members right now for coming so close. Let me also say that, if I believed that the Fed were targeting unit labor costs, I would be pretty confident that we would not see any further interest rate increases, at least not in the next 3 months (and certainly not this afternoon). When the economy is facing a possible recession and your target number is right where you want it, you don’t push things. (As it is, I don’t think the Fed is targeting unit labor costs, and I think there’s actually a significant chance of an increase this afternoon, contrary to the current consensus.)

You might want to look more closely at the second quarter figure. One reason it was so high is that productivity growth was slow. In general, one wouldn’t expect that weak productivity growth in a particular quarter means we should expect weak productivity growth in the future. Applying my smoother to productivity growth, I get a rate of 2.7%, compared to the 1.1% reported for the second quarter. So if we use trend productivity growth instead of the quarterly observation, that shaves 1.6 percentage points off that ugly 4% and leaves us with 2.4%, a much less alarming number.

The other side of the picture is compensation growth. Nominal hourly compensation grew quite rapidly (5.1% annual rate) in the second quarter. Does anyone expect it to keep growing at that rate? I certainly don’t, not after the recent huge drop in help wanted advertising.

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Anonymous Anonymous said...

Knzn sweet heart,

Expecting a sumptuous FED decision post and its impact on the dollar.

You are doing a lovely job on this blog.

Keep it up.


Tue Aug 08, 02:58:00 PM EDT  
Blogger spencerengland said...

Productivity growth lagged two quarters is a great leading indicator of real gdp growth --
compare the change in the y/y ch: of the two series.

But productivity growth implies a moderate slowdown in the second half and virtually no risk of a recession.

Tue Aug 08, 07:57:00 PM EDT  
Anonymous Anonymous said...

KNZN, I applaud your thoughtful analysis. You have no idea how many research reports came my way (I read a lot them) saying that productivity growth slowed. Not a single one mentioned how volatile the series is. Even the fed removed productivity growth from their statement. Do you think they are going to put it back in once productivity growth spikes back up?

Tue Aug 08, 09:19:00 PM EDT  
Blogger knzn said...

Spencer, I’m familiar with the typical business cycle pattern of productivity (because businesses respond initially to changes in demand by adjusting production without adjusting employment), but I’m not sure how you can say so confidently that productivity growth implies “virtually no risk of recession.” For example, productivity looked pretty good through the first half of 1990, but we had a recession in the second half: the productivity effect didn’t show up until the recession actually hit.

Tue Aug 08, 09:22:00 PM EDT  
Anonymous yc said...


The Fed must have read your post and be convinced by your labor costs still tame argument - they stop raising the rate!

Just kidding :)

Nice analysis.

Tue Aug 08, 10:42:00 PM EDT  
Anonymous yc said...

Oh, I forgot to ask you a question: now that the Fed stopped raising the interest rate, do you still think there will be a recession?

Jim Rogers said there would be a recession in a year. But since he admitted to Maria Bartiromo that he has been in short position in the market, I don't know how much I should trust his words.

Tue Aug 08, 11:25:00 PM EDT  
Blogger knzn said...

Anonymous (9:19:25), As Spencer’s comment and my response suggest, I think it’s likely that this bad productivity number represents a cyclical phenomenon, in which case it may persist for another quarter or two as businesses adjust to lower-than-expected levels of demand. Ultimately, of course, they adjust by reducing employment, which puts downward pressure on wages, so that the weak productivity growth actually signals a disinflationary phenomenon rather than an inflationary one. (Productivity growth tends to rise above trend again during the early stages of a recovery, as firms adjust to higher-than-expected demand.) If this scenario plays out then productivity will turn out to be largely irrelevant to the Fed’s subsequent decisions, at least until the recovery comes.

yc, I still think there will be a severe slowdown, which may or may not officially qualify as a recession. Really, 25 basis points on the federal funds rate do not make a whole lot of difference. As I said in the preamble to my earlier post, the Fed might pause “because there is evidence that the hard landing is already beginning to play itself out.” And if the hard landing evidence starts to diminish without an improvement in inflation, I think the Fed will continue to tighten, most likely precipitating the hard landing anyway.

Wed Aug 09, 10:04:00 AM EDT  
Blogger spencerengland said...

What bothered me about the report was that unit labor cost rose more then the deflator -- on a year over year basis they are now the same.

This seems inconsistent with the other reports that imply marginas and profits are still improving.

It makes me suspect that the 2nd Q gdp number and productivity will be revised higher.

Thu Aug 10, 03:36:00 PM EDT  
Blogger knzn said...

It makes me suspect that the 2nd Q gdp number and productivity will be revised higher.

Why not just the deflator revised higher, or compensation revised lower?

Thu Aug 10, 05:34:00 PM EDT  
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