📝 Productivity Data Shows Fed to Continue Its Tightening Path: Wells Fargo

Weak productivity growth makes the Fed's inflation challenge even harder. If workers are more productive, companies can afford to pay them more without pressuring profits or fueling a wage-price spiral. This isn't what we're seeing today. Unit labor costs (ULC), i.e., the productivity adjusted cost of labor, rose at a 10.8% annualized pace in Q2. This marks the second consecutive quarter of double-digit gains and suggests businesses continued to pay workers more to produce less. Output is still normalizing from pandemic-driven demand. But with labor being the biggest expense of many businesses, if labor costs continue to soar amid falling productivity, businesses will be forced to shed labor to protect the bottom line. They may also increasingly seek to invest in labor-saving technology to boost productivity.

Today's tight labor market has forced employers to step up compensation and has pushed “real” labor costs for employers well-above levels consistent with the Fed's 2% inflation goal. Of course ULC growth is exaggerated over the second quarter, and even first, but it is still way too strong even when smoothing over a year or two. The Fed simply can't get to 2% inflation with this sort of productivity and wage growth. Labor costs tend to be a stickier contributor to inflation, thus the Q2 productivity data position the Fed to continue on its tightening path until it sees wage growth subside and inflation moving meaningfully lower.

- Wells Fargo