Why wages are the hottest inflation signal for the Fed and markets to watch

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A billboard stands near the SMART Alabama, LLC auto parts plant and Hyundai Motor Co. subsidiary in Luverne, Alabama, July 14, 2022.

Joshua Schneyer | Reuters

The latest consumer and producer price data presented key evidence that inflation is slowing, but the one key inflation reading for the Federal Reserve that hasn’t subsided: wage growth. While the recent CPI and PPI came in below expectations and was greeted with relief by the market, the latest jobs report and wage growth data remain hot. How much of a problem is this for the Fed and the markets?

The good part of the recent jobs data is the suggestion that the economy may be able to avoid a recession. Worst-case scenario: the wage-price spiral feared by some economists since inflation took hold in the economy takes root. We know the Fed is watching wage growth closely. But several senior officials have said the goal is to keep wage growth at a level that allows Americans to outpace inflation, and the Fed has yet to indicate that it believes a wage-price spiral is in evidence.

Labor data could be the key by the fall, economists say, for a Fed caught between over-tightening and becoming dovish again too soon.

“The labor market is what keeps the Fed on its toes,” said Bledi Taska, chief economist at labor market research firm Lightcast. “Wage growth continues,” Taska said.

Even before the last monthly jobs report, the employment cost index, which the central bank monitors, showed a quarterly peak of 1.3%, with wages up 1.4%.

This payroll data has “scared everybody” at the Fed, according to Kim Rupert, managing director, global fixed income analysis for Action Economics. “They became aware of a wage-price spiral and it really affected them, threatened them and made them nervous,” she said.

Wage growth and homeowners’ equivalent rent inflation are the two factors that Rupert says are “really scaring the Fed right now,” even though other inflation data is moving in the right direction.

This is because wages and rents are more sticky than other inflation indicators, which tend to be volatile, such as food and energy. Along with salaries and rent, individuals tend to have a contract that is measured over at least a year. “Those are the risks for the future,” Rupert said. Wages and rents “will keep the Fed’s foot on breaks, but not trample them,” she added.

Other indicators point to the labor market cooling. Aside from the wage growth figure, one of the reasons overall hiring was so strong in July, economists say, is that it’s increasingly easier for companies to find people to onboard. .

“The bottleneck created because people quit their jobs, we’ve reached the top and we’re going to go down,” Taska said.

Signs of labor market slowdown even with high wages

This view is supported by the latest labor market data showing that employees are accepting positions faster. And while there is no indication from the Fed that it would consider suspending interest rate hikes until inflation drops significantly, the Fed’s latest release of its July FOMC minutes supports this view of a labor market that is not fully reflected in wage growth figures.

The Fed noted in its FOMC minutes that “nominal wage growth continued to be rapid and broad-based,” but it also said that “many participants also noted, however, that there were tentative signs of a softening of the prospects for the labor market”.

Rising initial weekly UI claims, lower quit rates and job vacancies, slower payroll growth than at the start of the year, and reports of reduced hiring in some industries were among the factors cited by the Fed. And the central bank said that “although nominal wage growth remained strong across a wide range of measures, there were signs of stabilization or slight decline”, with some contacts across the country saying “that imbalances between the supply and demand for labor could be reduced, with companies being more successful in hiring and retaining workers and facing less pressure to raise wages”.

While the labor force participation rate remains weak, many short-term labor market dynamics related to the pandemic are easing, economists say, and that’s another point the Fed addressed in its latest FOMC minutes. . The demand side of the Covid economy, meanwhile, is also running out of steam, according to Taska, pointing out that credit card debt and total household debt are both rising as stimulus savings are depleted.

“There was a lot of pressure from employees because at 5% wage growth they are still getting a pay cut,” Taska said.

But the biggest problem was competition for workers, and that’s why he thinks the labor market is approaching a point of equilibrium.

What in the pre-pandemic world was a local labor market is now a national market due to remote working and Taska says it has taken a long time for employers to realize this form of aggressive competition and adjust the job structure. wages. There is also still a backlog in obtaining board approval for annual salary budgets. “Now it’s better because they realize there’s no turning back,” Taska said.

“If you just look at the data, you don’t see the price-wage spiral as much as you see the macroeconomic underpinnings of people’s ability to find jobs,” according to Taska. “I expect the labor market to get a little less tight, hopefully not too much less. We can’t suppress wage growth too much.”

Companies, from their perspective, are worried about wage growth for another reason: productivity is falling as wages have been rising for several quarters, a lose-lose for employers. “A lot of people argue that something fundamental may have changed in the economy and there will be a decline in productivity forever,” Taska said. If that turns out to be true, that’s bad for inflation, as it will continue to keep price pressure on the producer side and ultimately trickle down to the consumer.

The way inflation went through the pandemic economy started with the demand shock, due to stimulus efforts, followed by the supply shock (which was exacerbated by the Russian-Ukrainian war) and what everyone trying to figure out now is the next phase of “the shock parade,” according to Glassdoor’s chief economist, Aaron Terrazas. “Will this turn into a price-wage shock? He asked.

Like the Fed, Terrazas remains skeptical of this idea. This is because most of the inflation has been driven by energy, other commodities and housing. While wages are “sticky” compared to other pricing pressures, they are also “plannable and predictable,” according to Terrazas, and can be gradually factored in as higher costs into other pricing.

He is also hesitant to over-interpret wage growth during an economic downturn because history shows that low-wage jobs are usually the first to disappear and this can artificially inflate short-term wage growth data. He pointed to wage growth in the downturns that occurred in 2008, during the “tantrum” of 2013 and 2014, and in March 2020.

The labor data the Fed will be watching

It is the vulnerability of the market’s perception of a “turning point” in the CPI that worries Terrazas more, as a new round of energy and food shocks in the fall and winter, he believes, could be what would create the conditions for a veritable 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 the market is getting a bit ahead of the bank. central. “We have the markets acting like a three-year-old in the back seat, asking ‘are we there already, are we there already? ‘” she said.

Rupert sees price pressures clearly stabilizing in the data, and that’s good news, but the downtrend is not yet certain. Like Terrazas, she’s focused on the employment cost index in the fall — “the dangerous time,” Terrazas called it, in terms of the upcoming data the Fed will be watching. It’s more important than any recent hot jobs report, he says, because there’s “a lot of inertia” in a nonfarm payrolls report that’s often mistaken for real-time momentum. of the labor market.

“By the time there is an executive decision to assign new staff, that translates to a payroll of two to six months,” Terrazas said. “So the hirings that we saw in June and July are, to some extent, a function of decisions made in March and April.”

For the next three to four quarters, Terrazas sees the risk of a higher reversal in food and energy costs, not wage growth itself, as the trigger to start worrying about a wage-price spiral. . “Three years of transitional shocks, and more food and energy inflation, then more pay reviews, and normally incremental wage increases are not enough, and then we really have to worry,” he said. he declared.

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