* The second quarter productivity report was confusing. On one hand, for the most recent quarter, productivity growth for the nonfarm business sector was higher and unit labor cost inflation lower than expected. On the other hand, the year- over-year gain in unit labor cost inflation was the highest since the third quarter of 2000.
* The disparity between the quarterly and year-over-year results for unit labor costs is due mainly to the volatility of the quarterly compensation data. These data appear to be volatile because a portion of compensation is tied to profitability and the exercise of stock options and both of these components tend to be lumpy. Unfortunately, the Bureau of Labor Statistics cannot tell us what portion of compensation costs is due to these factors.
* The year-over-year figures probably tell the more accurate story as they smooth out some of this lumpiness. However, we doubt that the underlying unit labor cost trend is as high as these figures suggest. In part, that is because the portion of compensation attributed to options exercise does not represent a current cash outlay by business.
* Despite the problems with the quality of the data, the underlying story remains one in which productivity growth has been slowing and unit labor cost inflation rising. This creates some upside risks in terms of inflation and is a factor encouraging the FOMC to continue to tighten monetary policy.