Labor costs slow, setting the stage for smaller Fed rate hike

REAL ECONOMY BLOG | January 31, 2023

Authored by RSM US LLP

Labor costs decelerated in the last quarter of 2022, adding to the justification for the Federal Reserve to slow its rate increases to 25 basis points after its meeting on Wednesday.

The index showed that labor cost growth fell to 1.0% on a quarterly basis, and to 5.1% on a year-ago basis for all workers, according to the Bureau of Labor Statistics’ Employment Cost Index released on Tuesday.

The Employment Cost Index is preferred as an indicator for labor costs over hourly wage rate data because the index is controlled for composition changes.

The question now focuses on when the Fed will decide to pause its rate increases. Based on the Employment Cost Index, we believe another 25 basis-point hike is needed in March to bring the Fed’s policy rate to 5%.

That figure would put the policy rate above the rate of increase in labor costs, a necessary condition for monetary policy to stay restrictive.

Containing wage growth has been a priority for the Fed because it is the core component of inflation that has remained stubbornly high amid a tight labor market.

Wage growth accounts for much of the inflation related to services, which are labor intensive. This is why Fed Chairman Jerome Powell has focused on core services excluding housing within the inflation data.

The takeaway

Following that logic, we believe it is necessary to focus on the service-providing number, which grew faster than all other categories at 5.2% year over year.

That supports our base case for another 25 basis-point increase in April, which would bring the interest rate to 5.25% and finish off the Fed’s round of increases.

But such an increase remains a coin flip and will depend significantly on the labor market, growth and inflation.