The Federal Reserve has another problem on its hands as companies put another quarter in the books amid sky-high inflation: falling productivity.
U.S. non-farm labor productivity, as measured by the Labor Department, fell in the second quarter at a seasonally-adjusted annual rate of 4.6%. That was the biggest year-over-year drop dating back to 1947 and the weakest back-to-back reading following a 7.7% drop in the first quarter, according to the Peterson Institute for International Economics (PIIE).
Meanwhile, employers spent more on wages and benefits. Analysis by Wells Fargo highlighted that unit labor costs (ULC) — the cost of labor adjusted for productivity — grew at a seasonally-adjusted annual rate of 10.8% in the second quarter.
"This marks the second consecutive quarter of double-digit gains and suggests businesses continued to pay workers more to produce less," Wells Fargo economists Sarah House and Shannon Seery explained in the report.
Although House and Seery cautioned that productivity readings can be volatile from quarter to quarter, they stressed that unit labor cost growth "is still way too strong even when smoothing over a year or two."
This creates another challenge for the Fed's plan to stem inflation while not tipping the economy into a recession.
"The trend in productivity growth has worsened compared to prior to the pandemic," the economists wrote, "and the surge in unit labor costs makes the Fed's challenge of getting inflation back down to its 2% target all the more challenging."
Fed, companies grapple with declining productivity
Over the past year, labor conditions have caused employers to offer more compensation to attract scarcer workers, which has pressured "real" labor costs for employers to run well-above levels consistent with the Federal Reserve's goal of 2% inflation over the long run.
Since labor costs are many businesses' largest expense, the economists cautioned that "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."
That, in turn, could reshape the Fed's expectations. The central bank has been increasing interest rates in an effort to raise borrowing costs, slow economic growth, and tamp down inflation.
"The Fed simply can't get to 2% inflation with this sort of productivity and wage growth," the economists said. "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."
PIIE noted that "productivity will not continue to decline like it did in the first half of 2022" and laid out two scenarios that could lead to more stable productivity.
Output could increase quickly "because the economy’s weaknesses were all in volatile components like inventories and net exports," PIIE nonresident Senior Fellow Jason Furman and research analyst Wilson Powell III wrote in the analysis.
Additionally, they added, employment could worsen "as employers rapidly shed labor that they determine they no longer need in an economy with much lower output."
In the long run, however, questions remain about how companies will grapple with productivity and filling vacancies.
"Will businesses be able to deploy pandemic-era innovations, including work from home, to operate at a sustained higher level or growth rate of productivity?" the PIIE experts asked. "Will other advances, like artificial intelligence, finally start to sustainably boost productivity growth? Or will the economy return to the relatively weak productivity growth of the pre-pandemic period or perhaps even something worse?"
Dani Romero is a reporter for Yahoo Finance. Follow her on Twitter @daniromerotv
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