The latest consumer and producer price data presented key evidence that inflation is easing, but the one key inflation read for the Federal Reserve that has not cooled off: wage growth. While recent CPI and PPI came in lower than expectations and were received by the market with relief, the latest jobs report and wage growth data remain hot. How much of an issue is that for the Fed, and the markets?
The good part of the recent jobs data is the suggestion that maybe the economy can avoid a recession. The worst-case scenario: the wage-price spiral that some economists have feared since inflation started taking hold over the economy becomes entrenched. We know the Fed is watching wage growth closely. But several top officials have said maintaining wage growth at a level that allows Americans to outpace inflation is the goal, and the Fed has not yet indicated it believes a wage-price spiral is in evidence.
Labor data may be the key between now and the fall, according to economists, for a Fed caught between over-tightening and becoming dovish again too soon.
“The labor market is the one to keep the Fed on its toes,” said Bledi Taska, chief economist at labor market research firm Lightcast. “Wage growth is continuing,” Taska said.
Even before the latest monthly jobs report, the Employment Cost Index which the central bank monitors showed a quarterly spike of 1.3%, with wages rising 1.4%.
That wage data “freaked everyone out” at the Fed, according to Kim Rupert, managing director, global fixed income analysis for Action Economics. “They turned conscious of a wage-price spiral and that really impacted them, and threatened them, and got them on edge,” she said.
The wage growth, and owners’ equivalent rent inflation, are the two factors that Rupert says are “really scaring the heck out of the Fed right now” even as other inflation data is moving in the right direction.
That’s because wages and rent are more sticky than other inflation indicators, which tend to be volatile, such as food and energy. With wages and rent, individuals tend to have a contract that is measured in at least one year. “Those are the risks going forward,” Rupert said. Wages and rent will “keep the Fed’s foot on the breaks, but not stomping the breaks,” she added.
By other indicators, the job market is cooling off. Outside the hot wage growth number, one reason the overall hires were so high in July, according to economists, is because it is getting easier for firms to find people to onboard.
“The bottleneck created because people are leaving jobs, we hit the peak of that and will trend downwards,” Taska said.
This view is supported by the latest labor market data showing employees are accepting positions faster. And even though there is no indication from the Fed that it would consider pulling back on interest rate hikes until inflation comes down substantially, the latest release from the Fed of its July FOMC minutes supports this view of a labor market that isn’t wholly reflected by the wage growth numbers.
The Fed noted in its FOMC minutes that “nominal wage growth continued to be rapid and broad-based,” but it also stated that “many participants also noted, however, that there were some tentative signs of a softening outlook for the labor market.”
Increases in weekly initial unemployment insurance claims, reductions in quit rates and vacancies, slower growth in payrolls than earlier in the year, and reports of cutbacks in hiring in some sectors, were among the factors the Fed cited. And the central bank said, “although nominal wage growth remained strong according to a wide range of measures, there were some signs of a leveling off or edging down,” with some contacts around the country saying “that labor demand-supply imbalances might be diminishing, with firms being more successful in hiring and retaining workers and under less pressure to raise wages.”
While the labor participation rate remains low, many of the shorter-term labor market dynamics related to the pandemic are easing, according to economists, and that is another point the Fed touched on in its latest FOMC minutes. The demand side of the Covid economy, meanwhile, is losing steam too, according to Taska, pointing to credit card debt and total household debt both increasing as the stimulus savings are exhausted.
“There was lots of pressure from employees because, at 5% wage growth, they are still getting a pay cut,” Taska said.
But the bigger problem was the competition for workers, and that’s why he thinks the labor market is coming closer to reaching an equilibrium point.
What had in the pre-pandemic world been a local market for labor is now a national market due to remote work and Taska says it took a long time for employers to realize that form of aggressive competition and adjust the wage structure. There also is always a lag in getting board approval for annual wage budgets. “Now it is getting better because they realize there is no way back,” Taska said.
“If you just look at the data you don’t see the wage-price spiral as much as the macro foundations of people being able to find jobs,” according to Taska. “I am expecting the labor market to become a little less tight, hopefully not too much less. We can’t suppress wage growth too much.”
Companies, from their point of view, are worried about wage growth for another reason: productivity has been declining as wages have been going up for several quarters, a lose-lose for employers. “Lots of people are arguing something fundamental might have changed in the economy and there will be lower productivity forever,” Taska said. If this turns out to be true, that’s bad for inflation, as it will continue to keep pressure on the producers’ side of prices, and ultimately flow through to the consumer.
The way inflation has run through the pandemic economy started with the demand shock, because of stimulus efforts, followed by the supply shock (which was exacerbated by the Russia-Ukraine war), and what everyone is trying to figure out now is the next phase in “the parade of shocks,” according to Glassdoor chief economist Aaron Terrazas. “Will it convert to a wage-price shock?” he asked.
Like the Fed, Terrazas remains skeptical of this idea. That’s because the bulk of inflation has been driven by energy, other commodities, and shelter. While wages are “sticky” compared to other pricing pressures, they are also “plannable and predictable” Terrazas says, and can be gradually incorporated as higher costs into other prices.
He is also hesitant to read too much into wage growth during an economic moment of softening, as history shows that lower-wage jobs are typically the first to go and that can artificially inflate the wage growth data in the short term. He pointed to wage growth into slowdowns that occurred in 2008, during the “taper tantrum” of 2013 and 2014, and in March 2020.
It’s the vulnerability in the market’s perception of a “turning point” in CPI that worries Terrazas more, because another round of energy and food shocks in the fall and into winter, in his view, could be the thing that creates the conditions for a true wage-price spiral.
Rupert said the stock market’s recent rally on the heels of a better inflation outlook and potentially lower risk of a Fed-induced recession is a sign that the market is getting a little ahead of the central bank. “We’ve got the markets acting like a three-year-old in the back seat, asking ‘are we there yet, are we there yet?’” she said.
Rupert sees price pressures that are clearly stabilizing in the data, and that is good news, but the downward trend isn’t certain yet. Like Terrazas, she is focused on the Employment Cost Index in the fall — “the dangerous moment,” Terrazas called it, as far as upcoming data the Fed will be watching. It is more important than any recent hot jobs report, he says, because there is “a lot of inertia” baked into a nonfarm payroll report that is often mistaken for a real-time pulse of the labor market.
“By the time there is an executive decision to allocate to new headcount, that translates into payroll anywhere from two to six months out,” Terrazas said. “So the hiring we’ve seen in June and July, to some degree, is a function of decisions made in March and April.”
For the next three to four quarters, Terrazas sees the risk of a reversal higher in food and energy costs, and not wage growth itself, as the trigger to start worrying about a wage-price spiral. “Three years of transitory shocks, and more inflation in food and energy; and then more compensation reviews, and normally gradual wage increases are not enough, and then we really have to worry,” he said.