Good morning.
Labor costs and wages are certainly topics that concern CFOs. But the U.S. Federal Reserve may be reassessing the viewpoint that wage growth boosts core inflation. Meanwhile, new research points to labor costs having a small effect on overall inflation.
Following continual interest rate hikes over the past 15 months—the most aggressive monetary policy since the 1980s—inflation fell for the 11th straight month to just 4% in May, the Bureau of Labor Statistics reported on Tuesday. Economists expect Federal Reserve Chairman Jerome Powell to announce a pause in rate hikes during the Federal Open Market Committee (FOMC) meeting today.
There's a “decent case for a pause,” but “not a definitive stop,” says Brett House, professor of professional practice in the Economics Division at Columbia Business School. “Core inflation is slowing, growth is cooling, labor markets are becoming more balanced, and inflation expectations are back in line with the Fed's 2% year over year target,” House says. “Yet consumer spending growth remains robust on the back of solid gains in disposable incomes."
The Fed remains concerned that wages and consumer spending are still growing more quickly than is consistent with the desired inflation target, according to House. “That said, growth in incomes is slowing toward pre-pandemic rates and this gives the FOMC some justification to consider a pause to wait and see what further data say,” he says.
When the economy began to reopen in mid-2021, and inflation began to increase, wages were on the rise as well. Some economists, including some at the Fed, were concerned that in a tight labor market, labor costs would play a big role in persistently high inflation. The spending category of "core services other than housing," may be "the most important category for understanding the future evolution of core inflation," Powell said in November 2022 speech. "Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category." The Fed subsequently sought to curb inflation with slower wage growth.
“The narrative up until recently has been that the Fed would focus on core services, excluding shelter, because that was the component that was subject to the most pressure from wages,” says EY Parthenon chief economist Gregory Daco. But if you look at some of the recent research that's been produced, and the developments in terms of wages, “we have not really seen that much of a passthrough from wages to inflation,” he says.
An analysis released in May by the Federal Reserve Bank of San Francisco finds that higher labor costs are passed along to customers in the form of higher non-housing services prices, but the effect on overall inflation is small. “Labor-cost growth has no meaningful effect on goods or housing services inflation,” according to the report. “Overall, labor-cost growth is responsible for only about 0.1 percentage point of recent core PCE inflation.”
“The Fed may gradually be reconsidering the way it frames its more hawkish discourse,” Daco says. “And I wouldn't be surprised to see the Fed focus more and more on the momentum in terms of core inflation and distance itself, to some extent, from wage growth dynamics.”
The value of talent has greatly increased post-pandemic, Daco says. “So, employers are very cautious when it comes to getting rid of their talent that they spent so long training, hiring, and retaining,” he says.
But if wage growth continues to crawl, some top talent may begin to walk.
Sheryl Estrada
sheryl.estrada@fortune.com
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