Labor costs rise, complicating Fed's decision on rate cuts

REAL ECONOMY BLOG | April 30, 2024

Authored by RSM US LLP

The employment cost index accelerated above expectations in the first quarter, complicating the Federal Reserve’s decision of when to start cutting its policy rate.

The index, a closely watched indicator of labor costs by the Fed, will almost certainly guarantee a more hawkish tone from the central bank at its meeting this week.

The index rose by 1.2% in the first quarter, up from 0.9% previously, while the year-over-year growth stayed elevated at 4.2%, according to data released Tuesday by the Bureau of Labor Statistics.

The acceleration explains the sizable rebound of core service inflation that excludes housing in the first quarter of the year, a metric that the Fed prioritizes to gauge underlying inflation.

The recent data is not what the Fed has been looking for in its campaign to restore price stability and and it might not be enough to convince the Fed, at least through July, that inflation is heading toward its target.

We think the first rate cut will most likely be pushed back to September once the data on the long-awaited housing disinflation is released.

But for workers, the change means goods news as their compensation and benefits have grown faster than inflation. Positive real wage growth is one of the main reasons why spending has kept surprising to the upside in the past couple of quarters.

Still, the rising wages put the Fed in a tough position as the central bank tries to strike a balance between keeping the labor market strong and taming inflation. To be clear, underlying inflation has remained between the 2.5% to 3% range, not as big of a concern as it was two years ago at 7%.

We are not alone in holding the view that the 2% inflation target is likely not the solution in the post-pandemic world. We think the Fed could comfortably tolerate inflation within 2.5% to 3% to keep the job market and wage growth robust. If inflation remains above 2%, the risks of the unemployment rate rising are also worth considering.

We believe the Fed wants to cut rates sooner rather than later because orderly and incremental rate cuts would always benefit the economy much more than waiting for cracks to appear in the economy, forcing sharp rate cuts.

But the Fed will remain hawkish to keep demand, and especially the financial markets, from running too hot.

Consumer confidence

In a separate report from the Conference Board on Tuesday, consumer confidence posted a significant drop in April falling to 97, the lowest since July 2022, from 103.1 as the rise in gasoline prices and decline in job prospects took a toll.

The labor differential index, which surveys jobs plentiful and jobs hard to get, dropped to the lowest level since November. The data supports our forecasts that April will show another strong but slower month of job gains with 240,000 net jobs added. The unemployment rate according to our forecast will most likely stay at 3.8%, below 4% for the 27th consecutive month.