U.S. Productivity: Exaggerated Softness in 1Q, But Strong Trend Driven by AI

Core Conclusion

First-quarter nonfarm business productivity growth of 0.8% q/q annualized appears weak on the surface, but the 2.9% year-over-year pace represents the strongest underlying trend outside cyclical recoveries since the late 1990s. The quarterly softness is largely a statistical artifact from residual seasonality, tariff-driven inflation, and oil price effects distorting the GDP deflator. The trend is real, structural, and AI-driven, with profound implications for inflation, corporate margins, and potential GDP.

The Trend Has Been Misread

The market fixates on the 0.8% Q1 print and dismisses productivity as stagnant. This is a framing error. Four-quarter productivity growth of 2.9% has accelerated from 2.0% a year earlier and from 2.3% in 4Q24. Excluding the pandemic-era goods-output surge (2020-21) and post-recession cyclical rebounds (2003, 2010), this is the strongest sustained productivity growth in nearly three decades.

AI Is the Primary Driver

The acceleration is not a labor-replacement story. Output growth, not employment contraction, is driving the improvement. Productivity gains are concentrated in industries with high AI exposure, especially technology sectors. Capital deepening explains much of the effect, but evidence of broader AI-driven benefits is beginning to emerge. This is not a catch-all judgment—it is directly observable in sector-level output and employment data.

Labor Cost Dynamics Are Not Inflationary—Nonlabor Costs Are

Unit labor costs (ULC) rose 2.3% q/q annualized in Q1 but only 1.2% y/y. That y/y gain is well below nonfarm business price growth of 3.5%—labor is not the marginal source of inflation pressure. The inflation problem resides in unit nonlabor costs, which surged 8.0% q/q in Q1, accelerating from 1.0% on a 4Q/4Q basis in 2024 to 6.3% over the four quarters through Q1. Tariffs are the mechanism. Nonlabor costs—imported materials, intermediate goods, and supply chain inputs—are rising far faster than final prices can absorb, squeezing business cash flow.

Key Divergence and Risk

The cleavage between healthy productivity (and labor cost) trends and surging tariff-driven nonlabor costs is the central feature of this data. Productivity strength lowers the equilibrium unemployment rate and expands potential GDP. Nonlabor cost pressure reduces corporate cash flow. If tariffs persist or escalate, the cash-flow squeeze will eventually force price pass-through or margin compression, either of which would alter the inflation-macro trajectory.

Key risks: (1) Tariff escalation keeps nonlabor costs elevated beyond 2026, eroding the productivity benefit to margins. (2) Residual seasonality could reverse Q2, making trend extrapolation unreliable for one more quarter. (3) AI-driven productivity gains remain concentrated in a narrow set of tech verticals—broad-based diffusion has not yet been confirmed.

Investment Implication

The market's focus on Q1 noise has created a gap between macro data and asset pricing. The productivity trend supports a higher neutral rate, lower cyclical unemployment, and better corporate margin resilience than current equity risk pricing incorporates. Sectors with high AI exposure and low tariff-sensitivity are the primary beneficiaries. Bond markets may be underestimating how productivity gains keep labor costs contained, reducing the urgency for the Fed to tighten into tariff-driven price spikes.

Appendix: Productivity & Cost Data Summary