Trade-offs stem from limitations of many origins, including simple physics. Take your refrigerator. It holds a certain volume of food and beverages. In preparation for this year’s Thanksgiving feasts, Americans will be making trade-offs for space by clearing their refrigerator shelves of leftovers and expired items so that turkeys or hams, sweet potato casseroles and pumpkin pies have room to be stored, then consumed. In cold climates, the choice of mittens over gloves tends to keep hands warmer with all fingers in the same compartment, but this also confines a full range of finger functionality. Large automobiles carry more people and cargo and have larger crumple zones, which make them safer in an accident. Heavier vehicles, however, have relatively poorer fuel economy. In chess, you might trade a pawn for an improved position. In a worst-case scenario, you accept the loss of the Queen to protect the most valuable King.
Any trade-off increases one thing but decreases another. In economics, this concept is duly evident in the association between productivity and unit labor costs. Over postwar history, the year-over-year (YoY) path for nonfarm productivity has a relatively strong inverse relationship of -.60 with YoY nonfarm labor cost growth. This said, the spread between productivity and labor costs is a distinctive guide altogether. When labor costs grow more quickly than productivity, widening the spread, inflation is pressured upwards. This was plainly evident toward the end of the 1990s and 2000s expansions, respectively (orange line). The Fed’s preferred measure of core PCE inflation (green line) drifted higher in each episode.
During the 2010s expansion, however, that wasn’t the case — and core inflation remained rangebound and squarely below the Fed’s 2% target. Employers have grown wise with each recession, ‘training’ each employee to produce more in exchange for keeping their job.
Through a different prism, the U.S./China trade war and COVID-19 pandemic reliably guide core inflation. While back-of-the-envelope calculations are gaming fiscal policies from the incoming Trump administration, today’s labor cost-productivity spread suggests that progress toward the Fed’s target could pause. At the margin, that could result in premium being built into short-term inflation swaps. Since Red wave expectations took hold at the beginning of October, one-year and two-year U.S. inflation swaps rose 50 and 40 basis points, respectively.
On a short-term basis, productivity also dictates corporate earnings growth. The ebb and flow of productivity over cycles has tracked – and even led – turning points in NIPA (National Income and Product Accounts) profits. You likely noticed that Federal Reserve Chair Jerome Powell positively referenced NIPA several times during yesterday’s post-FOMC presser. As for Thursday’s print, at 2.2% quarter-over-quarter, third-quarter U.S. productivity surprised to the downsides versus the consensus’ 2.5%. Moreover, the second quarter was revised down to 2.1% from the first-reported 2.5%. The rolling YoY trend thus ratcheted down to 2.1% from the first quarter’s recent high of 2.8% (light blue line).
Downside risk to the future path of productivity was advertised in the Institute for Supply Management’s (ISM) manufacturing and service surveys. Applying industry weights from GDP to their Output and Employment indices, and subsequently taking the spread, generates a productivity proxy. At the fourth quarter’s outset, a further downshift in this gauge to 4.0 extended the cooling from the first quarter’s 7.4 high point (yellow line). Official productivity and its proxy raise a red flag for second-half profits. The upshot is that the 10.9% YoY second-quarter gain will likely prove to be the interim peak (purple line).
With this as the backdrop, C-suite occupants’ focus must be shepherding their margins. Productivity enhancing endeavors and additional labor cost-cutting measures top their lists of things to (keep) doing. Measuring the former is not as easy as illustrating the latter. To that end, headcount reduction continues apace – 1.892 million in the week ended October 26 marked a fresh cycle high (red line). There’s been a steady whittling since April 19th’s 1.768 million.
Inconsistency arises in when you factor in the rise in insured unemployment to a fresh two-year low of 25% at the end of October (green bars). To be sure, rising recession probability and higher continuing claims ran up in tandem from 2022’s lows through the first part of 2023. Equally, the leveling off in continuing claims in 2023’s second half through early 2024 also coincided with a fall back in recession risk. The tension on display over the last six months has, no doubt, broadcast opposite messages. The defensive posture portrayed by two of the most cyclical sectors decides the vote between which of the two postures reflects reality. At 14.1% YoY, October’s YoY trend in the sum of manufacturing and wholesale unemployment defies economic expansion precedent (lilac line).
The signal to cut labor supply from the production and distribution channels determines whether product supply in these same sectors is amassed. The sum of manufacturing and wholesale durable goods inventories was applied for two reasons: 1) inventory data are nominal and 2) nominal nondurable inventories can be influenced markedly by swings in oil prices. The truer, underlying pulse of the supply build emanates from durables. While manufacturing and wholesale durable inventories have yet to register a YoY decline (September was 1.5% YoY) in the face of rising unemployment, recent performance has been uneven (two of last four months were down). Critically, September’s -0.3% monthly decline was the largest since March 2023’s -0.4%, itself the worst post-pandemic monthly performance. There’s no trade-off here but there is a crystal-clear justification for the Fed to keep jumbo cuts on the table.