The stock market should be supported this week by expectations of another strong quarter of corporate earnings to be reported in January. Although the next FOMC Meeting is not until the end of January, market "talk" also may center on the implications of strong productivity growth for monetary policy after last week's release of Q325 Real GDP. If strong productivity is sustained, it would point to strong growth with low inflation. It means that the Fed could still cut rates while GDP Growth is strong.
Productivity has been growing well above the trend seen in earlier years. The typical estimate of trend productivity in the 1990s and early 2000s was 1.0-1.5%. In 2024, the official measure of productivity rose 2.1% (Q4/Q4). In H125, productivity averaged 0.8%, but this weakening may be temporary. Using the difference between Real GDP Growth and Total Hours Worked (THW) as a proxy for productivity suggests strong productivity growth in H225. The proxy suggests the Q4/Q4 growth will be close to 2.0% -- similar to that of 2024 (see first table below). Note that this proxy has underestimated official productivity figures more often than not in recent quarters.
Higher trend in productivity growth means that faster GDP Growth need not put pressure on the labor market. The non-inflationary trend in GDP Growth would have moved up. With trend labor force growing about 1.0% per year (based on population growth), trend GDP Growth (sum of labor force and productivity growth rates) is likely around 3.0% rather than the 1.8-2.0% Fed estimate of longer-term growth. This pace should be consistent with both steady unemployment and inflation, if labor force participation rate is steady. The participation rate, however, has risen since July. If this is the start of an uptrend, labor force growth should continue to grow faster than the trend based on population growth alone and lift the Unemployment Rate further. It would allow economic growth to exceed 3.0% without stirring up inflation.
This combination would argue for the Fed to refrain from tightening while GDP Growth looks to be excessive from an historical perspective. Indeed, if AI is behind the ratcheting up of productivity growth and is resulting in fewer people being hired, the Fed should aim for even faster GDP than the higher trend growth rate.
To be sure, it is difficult to predict the trend in productivity or labor force participation ahead. The Fed has to judge whether sustained 3-4% Real GDP Growth will lead to higher inflation. How the Fed responds could depend on whether the economy is operating at full employment. At full employment, the risk is that the faster growth would result in higher inflation . Higher interest rates would be required to match the productivity-driven higher rate of returns on business investments. Otherwise, investments would accelerate and consumption be boosted by a stronger stock market, both possibly leading the economy into inflationary territory. At less than full employment, the Fed could allow more time to assess the possibility of sustained higher productivity (and labor force growth), keeping interest rates low and allowing the economy to grow faster than its earlier trend. Currently, the high 4.6% Unemployment Rate means that the fast GDP pace in Q325 and expected for Q425 should not stop the Fed from maintaining an accommodative monetary policy.
Besides an accommodating Fed, the productivity-driven faster GDP Growth is a positive for corporate profits. Consensus looks for about 8% y/y for S&P 500 earnings in Q425. Although this is below the near-15% gain seen in Q325, the risk is that the consensus estimate is too low.
The macroeconomic evidence supports strong corporate earnings in Q425. Real GDP Growth looks to be up sharply on a y/y basis in Q425 (see second table below). And the weaker dollar combined with better economic activity outside the US means that earnings from abroad should boost US company profits, as well. These pieces of evidence are stronger in Q425 than in Q325. Although profit margins may have been held down in Q425, as core inflation rose by less than wages, they could have been offset by the depressed pace of Payrolls -- holding down the "wage bill."
Annualized Growth Rate
Real GDP Growth Less THW Official Productivity Growth
Q124 0.5 1.7
Q224 2.8 2.9
Q324 3.0 2.1
Q424 0.4 1.6
Q4/Q4 1.7 2.1
Q125 -1.3 -1.8
Q225 2.3 3.3
Q325 4.3 na
Q425 * 1.7 na
Q4/Q4 1.8 na
* Using Atlanta Fed Model's early estimate of 3.0% (q/q, saar), for Q425 Real GDP Growth and November' THW to represent Q425 average.
Eurozone Real GDP Oil Prices Trade-Weighted Dollar AHE Core CPI Mfg PMI
[ y/y percent change ] (level)
Q124 2.9 +14.0 0.0 4.3 3.8 46.4
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