With all the fuss over the upcoming jobs report, investors seem to have overlooked an equally important piece of the economic puzzle: productivity.
In the first quarter, labor productivity rose at a 3.5% annual pace, up from 2.5% in the last three months of 2003. On a year-over-year basis it climbed 5.4%. While it's nice to have an efficient economy, and strong productivity keeps inflation low, it doesn't help the labor market.
Chairman Alan Greenspan and many economists say productivity will slow down this year, allowing for further job gains. But exactly when productivity will slow and by how much remains a mystery.
"Nobody knows for sure," said Jay Feldman, an economist at Credit Suisse First Boston.
What is clear, at least to Feldman, is that productivity gains will be stronger going forward than they have been historically. Productivity averaged 2.4% from 1996 to 2001, up from 1.6% in the previous 20 years, according to
. In the future, Feldman estimates it could average as much as 3.5%.
Labor productivity measures how much an employee produces per hour worked. When productivity is strong and employees are producing more goods or services each hour than they once did, businesses are able to increase their profit margins without raising prices. That's how inflation is kept in check.
Since 1990, productivity has risen steadily in the U.S. because technological developments (computers, communications and so on) have made production more efficient. But some say productivity has been robust in recent years because companies have been cutting costs, laying off employees and squeezing a lot more work out of those remaining. Hours worked rose 2.7% in the first quarter, mostly due to overtime.
Since the job market has been so bad over the past three years, employees haven't been in a position to demand large pay increases and this has given a further boost to corporate profits. Unit labor costs rose at a 0.5% annual rate in the first quarter but are still down 1.3% from last year.
"The bottom line is that strong productivity continues to dampen hiring plans and is keeping labor costs in check," said David Rosenberg, chief economist at Merrill Lynch.
In testimony before Congress in April, Greenspan said productivity growth "will doubtlessly slow from its recent phenomenal pace" as opportunities to cut costs become scarcer and demand begins to firm. "In such an environment, the pace of hiring should pick up on a more sustained basis," he said.
When businesses are convinced they have milked current employees as much as possible and that demand has truly picked up, they should increase hiring. And Feldman said there are already signs this is happening.
"Extracting productivity gains out of existing labor input is a finite process -- you can't keep doing it, and firms are starting to find it necessary to increase their labor input to satisfy the strong demand growth," he said.
The employment report Friday will say a lot about just how much the business climate has changed. In general, economists believe that 165,000 jobs were added in April.
Of course, if productivity does slow down this year and the labor market improves, inflation is also likely to rise from its current low level. Some economists expressed concern about the small rise in labor costs during the first quarter, which they view as a precursor to higher inflation.
"The tide is turning, as the economy evolves toward an environment of slower productivity growth and more rapid job growth," wrote John Johnston, an economist at RBC Capital Markets. "This has significant medium-term implications for inflation (potential upside risks) and monetary policy (tightening is coming)."
Still, Feldman said inflationary pressures will probably take time to build. "
Inflation may not rise a lot and it may not rise right away. ... Profit margins are historically very wide and unit labor costs are still down on a year-over-year basis," he said. "So it might be a long way to go before you're really seeing the kind of cost pressures that could spark inflation."
For now, of course, it's not clear that productivity is slowing down to any significant degree. And given the implications for employment and inflation, it's probably something investors should be paying more attention to.