After Productivity Spike, Expect More 3Q Pleasant Surprises

The highly important productivity figures released Tuesday showed an annualized increase of 6.4% for the June quarter, better than most expectations of a gain in the mid-5% range. Compared with the first quarters coming out of past recessions, the gain was pretty typical: The average post-recession gain is just over 6%. However, unlike most past recessions, productivity did not fall meaningfully during the recession itself, as employers cut jobs quickly. So normally, I would have expected a more muted productivity gain coming out the other side of this recession.

The spike in productivity is a good indicator that the end of the recession is at hand. Most big spikes I have seen in productivity have occurred in the quarter when economic activity bottoms, which is consistent with my thesis that the recession ended in the June quarter. The high productivity results are good news for the Fed, too. Higher productivity means lower pressure on prices, which gives the Fed more room to maneuver with its interest-rate policies. From an employment viewpoint, higher productivity means that employers were pressing their employees extra hard, and as activity begins to pick up, employers may be forced to hire workers faster than past recessions. This could be where the surprise comes to most economic forecasts, too.

Corporate profits are also strongly affected by productivity gains. Increased labor productivity was a key factor in explaining why more than 70% of major corporations reported positive earnings surprises in the June quarter earnings. However, sales were down and provided far less upside surprises. If a sales gain is coupled with costs only a little above second-quarter levels, the third quarter could provide another upside surprise.

So far, the strong productivity growth throughout the current recession has come as hours worked have decreased faster than production has decreased. Employers laid off workers faster than actual production declined. For the third quarter, I think productivity can make another good showing as production actually increases, perhaps dramatically, while hours worked show relatively modest increases.

Productivity Over the Long Term
Volatility and restatements sometimes make the productivity numbers hard to interpret over the short term, but productivity is the single most important factor for predicting the long-term growth rate of the economy. Typically, the long-term trend has varied from between 1.5% and 3%. (The other major factor for determining GDP growth is population changes, which have ranged in the 1%-2% range.) While a lot of economists are negative on the economy over the longer term because of a combination of bigger deficits, higher taxes, constrained resources, and demographics, potentially higher growth rates driven by higher productivity could offset a lot of these negatives.

Without trying to be exacting about this, a 1.5% productivity growth rate and no population growth would put our economy in a world of hurt over the next 20 years. The economy would be buried under the weight of our deficits at this level of growth. On the other hand 2.5%-3% productivity growth combined with a 1% population growth rate would cure many of our economic ills, including our budget deficits. It is too early for me to weigh in on which scenario is more likely now. More savings, investment, and world trade fall on the positive side of the argument, while poor tax policy, restrictions and limits on innovation, and poor immigration policies weigh on the downside.

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