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High labor costs fuel debate at Fed about what it means for inflation


As the U.S. economy reopened from the pandemic in 2021 and companies realized the pricing power at hand from supply shortages and consumers’ eagerness to spend, corporate profits spiked to claim the highest share of national income in 60 years.

Profits would claim more than 15.5 cents on the dollar that year and the next, a full 2 cents higher than the average of 13.5 cents from 2010 to 2019.

That surge is now driving debate inside the U.S. Federal Reserve about how much weight to give ongoing wage increases as policymakers assess the path of inflation and debate how much higher interest rates need to go to tame it.

New data released Friday are likely to intensify the discussion.

A closely watched measure of inflation, the personal consumption expenditures index excluding food and energy, was unchanged on a monthly basis at 0.3%, and at an annual pace of 4.6% remains well above the Fed’s 2% target.

Labor costs, meanwhile, rose faster than expected, with the Employment Cost Index increasing 1.2% for the months from January through March versus the 1.1% projected by economists in a recent Reuters poll.

Together the results solidified the outlook the Fed will raise its benchmark policy rate by another quarter percentage point at its meeting next week, and could, analysts said, push the bias towards even tough monetary measures.

“The story is ECI being higher than expected,” said Joseph Lavorgna, chief U.S. economist with SMBC Nikko Securities in New York. “Powell is going to err on the side of being hawkish.”


The Fed’s tone next week, however, will depend on how policymakers put a number of pieces together. Inflation is improving more slowly than expected, for example, but there are some signs demand is beginning to cool. The ongoing increases in employment costs could be a sign the job market remains too tight, or, in an alternate view among some Fed economists and officials, be seen more as a correction that won’t necessarily feed higher inflation.

Staff at the Atlanta Fed, noting that over the last two years the larger share of profits carved from higher prices came at the expense of labor’s portion, argue wages could continue rising somewhat without causing inflation since the profit side has room to give back.

Chicago Fed research has argued wages say more about what happened with prices in the past than they do about what will happen in the future, while St. Louis Fed economists have said that, regardless of the pace of wage growth now, once excess savings for the pandemic years are spent both the rates of inflation and wage growth should decline.

“You have to go back several decades to see a time when the profit share of price has been as high as it is now,” John Robertson, an economist and senior policy advisor at the Atlanta Fed, told Reuters earlier this month. “If profit margins were to come back down to the normal, pre-COVID level, that would give some room for labor’s share to increase and still have everything work out” for inflation to return to target.

The rate increase expected next week would lift the benchmark federal funds rate to a range between 5% and 5.25%.

But policymakers will also have to indicate if they are ready to pause further rate increases after next week or not, a decision that hinges on whether they think inflation is now on a durable downward path.

To some, the current low unemployment rate of 3.5%, coupled with the fact that inflation has become more concentrated in labor-intensive service industries, is reason for concern.

Fed Chair Jerome Powell has focused in particular on the persistence of inflation in the service sector outside of housing, and after the March meeting of the Federal Open Market Committee said progress there “will have to come through softening demand and perhaps some softening in labor market conditions. We don’t see that yet.”

But the share of each dollar of output going to workers at nonfinancial corporations averaged 58.3% in 2022. While that was above the level typically seen prior to the pandemic, the labor share had been rising steadily from 2013 on and hit 59.3% in 2019. Until a wave of globalization in the early 2000s it was well above 60%.

“The one thing that I think we’re spending too much time looking at is wage growth as an indicator of prices,” Chicago Fed President Austan Goolsbee told CNBC this month, citing recent research by Chicago Fed staff. “They’re a lagging indicator…When people are looking at what’s happening to wages now, that’s more reflective of what happened to prices six months ago.”

St. Louis Fed Assistant Vice President Michael McCracken, in comments to Reuters earlier this month, said he views much of what is happening with wages and prices today as the result of extra savings – still estimated by some economists to be in the hundreds of billions of dollars – that households accumulated during the pandemic months and are still spending.

He said he views rising wages as the result of that still- strong demand, something that should ease alongside price pressures once the money is gone.
It was an argument heard more frequently in the early days of the pandemic, but McCracken said when he sees the crowds on airplanes or the perpetually packed parking lot at his favorite restaurant “it just makes way too much sense.”

“We burn through those excess savings…and then we’re all good,” McCracken said, an outcome he feels could be obtained without a major raise in unemployment.

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