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Filippo Occhino |

Senior Research Economist

Filippo Occhino

Filippo Occhino is a senior research economist in the Research Department at the Federal Reserve Bank of Cleveland. His primary areas of interest are monetary economics and macroeconomics. His recent research has focused on the interaction between the risk of default in the corporate sector and the business cycle.

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Jessica Ice |

Research Analyst

Jessica Ice

Jessica Ice is a research analyst in the Research Department of the Federal Reserve Bank of Cleveland. Her primary interests include international economics, foreign exchange policy, economics of education and labor markets, and economic history.

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03.10.14

Economic Trends

How Fast Will Labor Productivity Grow in the Long Run?

Filippo Occhino and Jessica Ice

Labor productivity in the nonfarm business sector grew rapidly in the second half of 2013, reaching an average 2.63 percent annual rate. This was the fastest two-quarter pace since the boost of productivity growth associated with the end of the Great Recession and the beginning of the recovery. Meanwhile, labor compensation per hour grew much more slowly over the same period, at an average 1.5 percent annual rate. The combination of fast productivity growth and moderate labor compensation growth reduced unit labor costs—the average labor compensation for the production of one unit of output.

Productivity, Compensation per Hour and Unit Labor Costs

  Productivity Compensation per Hour Unit Labor Costs
2013:Q4 1.78 1.65 −0.12
2013:H2 2.63 1.50 −1.09
2013 1.30 0.38 −0.93
Since 2009:Q3 1.59 2.16 0.62

Notes: Nonfarm business sector. Q4 indicates the fourth quarter; H2 indicates the second half of the year.
Sources: Bureau of Labor Statistics, authors’ calculations.

Such a fast pace of productivity will not last long though. Productivity growth is very variable in the short run and can diverge substantially from its underlying long-term trend. Over the business cycle, changes in productivity are typically associated with temporary changes in the utilization rates of capital and labor, often in response to temporary changes in the demand for output, and do not necessarily reflect any permanent, more fundamental changes in trend productivity. In the second half of 2013, output grew rapidly at an average 4.45 percent annual rate, and this likely boosted productivity growth temporarily.

Forecasting the long-run growth of labor productivity is important because it helps to determine the long-run growth rates of wages, per-capita income, and aggregate output. One way to forecast future long-run growth is to consider how trend productivity has grown in the past. From 1948:Q1 to 1973:Q1, labor productivity in the nonfarm business sector grew rapidly at an average 2.9 percent annual rate. Then, the average annual growth rate dropped to a modest 1.46 percent between 1973:Q2 and 1997:Q1, accelerated to 3.6 percent between 1997:Q2 and 2003:Q4 (a period associated with new information and communications technologies), and declined again to 1.63 percent afterward. The most recent productivity slowdown began well before the Great Recession, in the first half of the 2000s, as the economist John Fernald emphasized in 2012.

Based on this evidence, the best estimate for the current trend productivity growth rate is close to the post-2003 average, 1.63 percent per year. This estimate is surrounded by large uncertainty though. More importantly, the fact that trend productivity growth has varied so widely in the past suggests that the future growth rate may diverge substantially from the current one.

Another approach to forecasting future productivity growth consists of forecasting separately each of the factors that determine labor productivity in the long run: capital deepening, labor quality, and total factor productivity. Labor productivity rises when workers have more and better capital to work with (capital deepening). It also rises when the average labor quality (skills, education, etc.) of the workforce improves. Finally, it rises because of other factors that improve the productivity of capital and labor, such as research and development, new technologies, efficiency gains in production processes, etc. (total factor productivity). Using this approach, Fernald forecasted that labor productivity in the nonfarm business sector will grow at a 1.9 percent annual rate. Another economist, Robert Gordon, forecasted in a 2010 paper that it will grow at a 2.05 percent annual rate in the years 2007 through 2027, the result of a 0.85 percent contribution from capital deepening, a 0.15 percent contribution from labor quality improvements, and a 1.05 percent contribution from total factor productivity.

The Congressional Budget Office’s projections focus on a slightly different concept, potential labor productivity, the labor productivity corresponding to a high utilization rate of capital and labor. In the long run, actual and potential labor productivity will grow at the same rate. According to the Congressional Budget Office’s estimate, potential labor productivity is rising at a 1.65 percent annual rate in 2014. In the next decade, it will first accelerate and then decelerate, following a pattern analogous to capital services. In 2024, potential labor productivity is forecasted to grow at a 1.77 percent annual rate, of which 0.58 percent is due to capital deepening.

Taken together, these results suggest that the best forecast for the long-run labor productivity growth rate in the nonfarm business sector lies in the range between 1.63 percent and 2.05 percent. Productivity in the overall economy will likely grow a few tenths of a percentage point slower than in the nonfarm business sector, as has been the case in the past. Any forecast of future productivity growth is surrounded by very large uncertainty though, so future productivity growth may turn out to be different from these forecasts.