Productivity rebound overstates momentum amid visible trade shock

Nonfarm productivity rose 2.4% in Q2 2025, but persistent challenges threaten growth.

Nonfarm business sector labor productivity rose 2.4% annualized in Q2 2025, following a downwardly revised 1.8% contraction in Q1, as economic output increased 3.7% and hours worked advanced 1.3%. Unit labor costs rose 1.6% in Q2 as compensation growth cooled to a still-elevated 4.0% pace.

Just as the productivity black eye in Q1 reflected tariff-induced disruptions to net exports caused by front-loading of imports, the strong Q2 rebound likely overstates the true underlying momentum. Averaging the 1.8% contraction in Q1 with the 2.4% advance in Q2 reveals a lackluster 0.3% gain in H1—well below the 2.3% average quarterly increase recorded in H2 2024.

The annual trend in nonfarm business sector productivity growth picked up 0.1 percentage point (ppt) to 1.3% year over year (y/y) in Q2 2025. While the pace has slowed compared to early 2024, it remains near the upper end of the 2010–2019 range. The type of pro-cyclical productivity momentum seen in 2023–24 had only occurred once in the past two decades – during the 2000–2005 period. Unfortunately, the latest data points to a self-inflicted supply shock from tariffs, immigration restrictions and persistent policy uncertainty – driving up inflation and weighing on both economic activity and productivity growth.

Compensation growth rose 0.7ppt to 3.9% y/y in Q2, despite clear signs of labor market cooling. Factoring in modest productivity growth of 1.3% y/y, unit labor costs rose 0.6ppt to 2.6% y/y – down from a 6.4% peak in 2021. Strong compensation is a luxury that businesses can only afford in a high-demand and/or high-productivity environment that offsets elevated labor costs. With both factors under pressure, we expect compensation growth to moderate in the months ahead.

The foundations of US exceptionalism are weakening as labor market conditions soften, income growth slows, policy and trade uncertainty rise, immigration constraints chill business activity, and institutional stability comes under threat. As these pressures mount, firms are finding it increasingly difficult to preserve margins without resorting to job cuts.

In this environment, productivity is more than a buffer; it’s a lifeline. It helps anchor inflation and supports more resilient growth. Recent gains — driven by experienced labor, automation, operational efficiency and strong business formation — remain intact. But rising trade and immigration barriers, combined with ongoing policy uncertainty, continue to weigh on business confidence and delay critical investment.

Encouragingly, generative AI (GenAI) is beginning to accelerate capital, research and development, and software investment, reinforcing the prospects for meaningful productivity gains. Over the coming years, this momentum will likely become essential.

The views reflected in this article are the views of the author(s) and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.