The secret ingredient to a soft landing is … strong productivity

Nonfarm business sector labor productivity growth advanced a moderate 2.2% annualized in Q3 as economic output rose 3.5%, and hours worked increased 1.2%. Over the last six quarters, productivity growth has averaged an impressive 2.6% increase per quarter. This type of pro-cyclical productivity momentum has only occurred once in the past two decades, during the 2000-2005 period. 
 

Factoring the National Income and Product Accounts (NIPA) revisions, nonfarm business productivity was revised higher by about 1%, but the annual pace of growth was revised down gently. As such, the annual trend in productivity growth cooled 0.4 percentage point (ppt) to 2.0% year over year (y/y) in Q3 2024. Still, it remains above the 2010-2019 range (excluding recession-induced distortions when productivity surges because labor falls faster than output) and the strongest since the early 2000s. 
 

Strong productivity growth in Q3 was disinflationary with unit labor cost only rising a moderate 1.9% in Q3 despite a solid 4.2% gain in compensation. The annual pace of growth of unit labor costs firmed by 0.2ppt to 3.4% y/y in Q4, down from a peak of 6.4% y/y in 2021. We know from the recent Employment Cost Index that wage compensation growth is easing, but one should acknowledge that strong compensation growth is a luxury businesses can only afford in a high-productivity growth environment.
 

Overall, upward revisions to income growth, pro-cyclical productivity growth and strong labor force participation remain the key pillars to the US economic outperformance. If firms can generate strong productivity momentum, they will be able to control costs and protect margins without sacrificing talent in an environment of still-elevated wages and fading pricing power.
 

The Federal Reserve is likely to cut the federal funds rate by 25 basis points (bps) this afternoon. Ongoing disinflation and softening labor market momentum along with strong productivity growth should favor a gradual recalibration of Fed policy following an outsized 50bps “catch-up” rate cut in September. We anticipate another 25bps rate cut in December, but we will likely be dialing back our monetary policy easing expectations for 2025, factoring in an altered trade, tax and regulatory policy landscape following the election results.