By Jeffry Bartash
Rising labor costs are the Fed’s biggest inflation worry
The cost of living fell in December for the first time in two and a half years, and inflation is clearly on the wane. But the danger to the U.S. economy is not over yet.
The Federal Reserve’s biggest worry about inflation is a rapid rise in wages over the past year due to an ultratight labor market in which companies have to compete for workers.
If workers keep asking for and getting higher pay, the thinking goes, inflation won’t return to the low and stable level — 2% or less — that prevailed before the pandemic.
Yet a key measure of labor-related inflation in the consumer price index in December still shows plenty of upward pressure on wages.
Senior Fed officials are paying close attention to a figure extrapolated from the CPI report called “service prices minus energy and shelter.”
Why this number? Most U.S. businesses provide services — think banks, hospitals and restaurants — and labor is their single biggest expense.
The index increased 0.3% in December, up a tick from the prior month.
What’s more, the yearly increase in that labor-related service index remained stuck at 6.3% in December — triple the typical increase each year in the decade before the pandemic.
“The acceleration in services inflation will bother the Fed,” said Ryan Sweet, chief economist at Oxford Economics. “Services prices are stickier than goods prices, and this is going to be a noticeable source of inflation through the first half of the year.”
Adding to the problem, the labor market remains as tight as ever. The economy added a robust 223,000 new jobs in December and unemployment fell to 3.5%, to match the lowest level since the 1960s.
New applications for unemployment benefits, meanwhile, also sit near historic lows, an indication that few people are being laid off.
“Overall demand for services, and therefore growth in service costs, are likely to persist as long as U.S. consumer demand and the labor market remain strong,” said Cailin Birch, global economist at the Economist Intelligence Unit.
The December employment report did show annual wage growth slowing to 4.6%, but that’s still well above prepandemic levels and too high for the Fed.
“The Fed is likely to want to see the labor market cool off significantly more than it has to date,” said Joshua Shapiro, chief economist at MFR Inc.
Some economists believe wage growth is already fading as the economy slows and businesses take defensive measures in case of a recession. They predict the upward pressure on wages will continue to ease.
The service index the Fed follows suggests there might be something to that.
The annual rate of growth in the index during the three months from October to December slowed to 2.7% from 4.9% in the prior month and from a pandemic peak of 10% in June, putting it closer to the prepandemic trend.
Yet the index is often up and down, so the Fed wants to see more evidence that wage growth is softening.
Stephen Stanley, chief economist at Amherst Pierpont Securities, contends that wages won’t fall back to prepandemic levels soon and that the Fed faces a big challenge in getting inflation down to its 2% target. The yearly rate of inflation slowed to 6.5% in December from 7.1% in the prior month and from a 40-year peak of 9.1% last June.
“My sense is that the first few percentage points of inflation moderation will have been relatively easy,” Stanley said, “but it is likely to get harder after we get down to the 4% to 5% range.”
(END) Dow Jones Newswires
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