Productivity black eye is misleading

Q1 2025's 0.8% decline in labor productivity misleads, reflecting tariff impacts rather than genuine economic weakness.

Nonfarm business sector labor productivity fell 0.8% annualized in Q1 2025 as economic output decreased 0.3% and hours worked increased 0.6%. Unit labor cost rose a solid 5.7% in Q1 as compensation growth accelerated to 4.8%.
 

The productivity black eye reflects disruptions to net exports caused by the imposition of tariffs and heightened policy uncertainty rather than genuine weakness in output. Case in point, manufacturing productivity surged by 4.5% in Q1, driven by a robust 5.1% increase in manufacturing sector output against a modest 0.5% rise in hours worked.
 

The annual trend in nonfarm business sector productivity growth cooled 0.7 percentage points (ppt) to 1.4% year over year (y/y) in Q1 2025 — its lowest since Q1 2023. Still, it remains near the upper end of the 2010-2019 range (excluding recession-induced distortions when productivity surges because labor falls faster than output). As we have previously stressed, this type of pro-cyclical productivity momentum has only occurred once in the past two decades, during the 2000-2005 period.
 

Strong compensation is a luxury that businesses can only afford in a high productivity growth environment that helps curb elevated labor costs. Indeed, despite solid compensation growth at 2.7% y/y in Q1, unit labor costs only rose 1.3% y/y in Q1 — down from a peak of 6.4% y/y in 2021.
 

In Q1 2025, headline Employment Cost Index compensation eased 0.2ppt to 3.6% — the slowest since Q2 2021 — while private sector wage growth slipped 0.3ppt to 3.4% y/y, its lowest since Q1 2021. As expected, both measures are in line with the 3.4% pace associated with 2% inflation and 1.4% productivity growth. The labor market is no longer a source of inflationary pressures.
 

Pro-cyclical productivity growth, a resilient labor market and solid household income gains remain critical pillars of US exceptionalism. However, the durability of these pillars is being tested. With tariffs increasing the cost of goods sold and market volatility intensifying amid policy uncertainty, the ability of firms to maintain margin discipline without resorting to labor shedding is under pressure. In this environment, productivity gains are not just a buffer — they are a lifeline.
 

The sources of recent productivity momentum — more experienced labor, targeted automation, efficiency enhancements and robust business formations — remain intact, but new headwinds are emerging. Elevated tariffs on key trading partners are straining supply chains and squeezing profit margins. At the same time, a lack of clarity on tax, regulatory and immigration policies is eroding business confidence and delaying investment decisions. While the promise of generative AI (GenAI) remains real, the near-term challenge is navigating these headwinds without derailing the productivity recovery.