Houston, We Have an Inflation Problem
Maybe Chair Powell wouldn’t have been so quick to dismiss a 75-bp rate hike in June had the latest unit labour cost report landed a day earlier. The horrendous release will only fan the inflation flames and the Fed’s expeditious drive to neutral and possibly beyond. Among nonfarm businesses, labour productivity plunged 7.5% (annualized) in Q1, more than reversing the prior quarter’s pop. This sent unit labour costs surging 11.6%, despite a moderation in hourly compensation growth (3.2%), lifting the yearly rate to 7.2%, the highest since 1982. Not coincidentally, that’s the last time we saw a 6.5% core CPI print.
The data from this report are notoriously whippy, but, even after smoothing, the trends are deeply concerning. Averaged over four quarters, productivity growth has slowed to just 0.8% y/y, the weakest rate in nearly five years. Rapid adoption of high-tech gear was supposed to make workers more productive, but it seems this benefit has been outweighed by the need to fill a record number of job openings with lower-skilled workers. As well, the record number of people quitting their jobs has led to continual staff turnover, with new hires bolting before they are fully trained (or even showing up for their first day on the job, as Manpower says “ghosting” is at a record high). While growth in compensation per hour has levelled off recently, it’s still above 5%. This, together with sagging productivity, is keeping unit labour costs on an upward keel, now at a 39-year high of 4.6% by this smoothed measure.
Perhaps most concerning is that compensation growth could resume climbing if workers seek bigger wage gains to compensate for high inflation. Some recent softness in average hourly earnings might only be a head-fake given the rebound in lower-paying leisure and hospitality jobs. Prospects for a wage-price spiral depend critically on long-term inflation expectations. So far, five-year forward TIPS pricing doesn’t suggest a major problem, as expectations beyond five years have steadied at around 2.5%, though this is still the highest rate in eight years. The Fed’s last remaining hope to achieve a soft landing hinges on inflation expectations staying relatively well-behaved. If not, a neutral rate won’t cut it, and nor will aiming to cool inflation largely by reducing job vacancies instead of actual employment, as Powell appears to be hoping for.
The Fed is in for the fight of its life to restore price stability in the face of old-fashioned excess-demand pressures arising from earlier loose policies. At least it can control this key force on inflation, albeit with long and variable lags. It can’t control the numerous other factors now pressing on inflation, such as, the EU’s looming ban on Russian oil imports or China’s lockdowns upending global supply chains. The Fed’s luck—which has been wholly bad this year—will need to turn around soon for it to have a reasonable chance of a soft landing. Policy is now riding on a wing and a prayer, which likely explains the extreme rockiness in financial markets.
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Sal Guatieri
Senior Economist and Director
Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with two decades experience as a macro economist. With BMO Financial Group since 1994, his m…(..)
View Full Profile >Maybe Chair Powell wouldn’t have been so quick to dismiss a 75-bp rate hike in June had the latest unit labour cost report landed a day earlier. The horrendous release will only fan the inflation flames and the Fed’s expeditious drive to neutral and possibly beyond. Among nonfarm businesses, labour productivity plunged 7.5% (annualized) in Q1, more than reversing the prior quarter’s pop. This sent unit labour costs surging 11.6%, despite a moderation in hourly compensation growth (3.2%), lifting the yearly rate to 7.2%, the highest since 1982. Not coincidentally, that’s the last time we saw a 6.5% core CPI print.
The data from this report are notoriously whippy, but, even after smoothing, the trends are deeply concerning. Averaged over four quarters, productivity growth has slowed to just 0.8% y/y, the weakest rate in nearly five years. Rapid adoption of high-tech gear was supposed to make workers more productive, but it seems this benefit has been outweighed by the need to fill a record number of job openings with lower-skilled workers. As well, the record number of people quitting their jobs has led to continual staff turnover, with new hires bolting before they are fully trained (or even showing up for their first day on the job, as Manpower says “ghosting” is at a record high). While growth in compensation per hour has levelled off recently, it’s still above 5%. This, together with sagging productivity, is keeping unit labour costs on an upward keel, now at a 39-year high of 4.6% by this smoothed measure.
Perhaps most concerning is that compensation growth could resume climbing if workers seek bigger wage gains to compensate for high inflation. Some recent softness in average hourly earnings might only be a head-fake given the rebound in lower-paying leisure and hospitality jobs. Prospects for a wage-price spiral depend critically on long-term inflation expectations. So far, five-year forward TIPS pricing doesn’t suggest a major problem, as expectations beyond five years have steadied at around 2.5%, though this is still the highest rate in eight years. The Fed’s last remaining hope to achieve a soft landing hinges on inflation expectations staying relatively well-behaved. If not, a neutral rate won’t cut it, and nor will aiming to cool inflation largely by reducing job vacancies instead of actual employment, as Powell appears to be hoping for.
The Fed is in for the fight of its life to restore price stability in the face of old-fashioned excess-demand pressures arising from earlier loose policies. At least it can control this key force on inflation, albeit with long and variable lags. It can’t control the numerous other factors now pressing on inflation, such as, the EU’s looming ban on Russian oil imports or China’s lockdowns upending global supply chains. The Fed’s luck—which has been wholly bad this year—will need to turn around soon for it to have a reasonable chance of a soft landing. Policy is now riding on a wing and a prayer, which likely explains the extreme rockiness in financial markets.
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