Through the spring and summer, most of the news from the labor markets has been encouraging for the inflation outlook. Job growth has slowed, and the unemployment rate has stopped falling. August payrolls increased by 128,000, right on the average monthly gain over the past six months but below the 165,000 mark during 2005. Last month's jobless rate, at 4.7%, remained in the 4.6%-4.8% band it has been in all year after a steady decline. These trends suggest a cooler pace of overall growth that will ease price pressures, and they have been instrumental in giving the Federal Reserve leeway to stop hiking interest rates -- at least for now.
However, are the inflation signals coming from the labor markets really as benign as they appear? Despite smaller increases in payrolls, the job market remains tight enough to keep pushing up labor costs. Hourly pay of production workers in August, up 3.9% from a year ago for the third month in a row, continued to grow at the fastest pace in five years. More important, a broader quarterly measure of hourly compensation, which covers all workers and other forms of pay such as benefits and bonuses, is growing significantly faster.
In fact, revised data from the Labor Dept. on Sept. 6 show that productivity growth, while very good, is nowhere near fast enough to offset the impact of rising labor costs on businesses. Through the second quarter, updated numbers show productivity, measured as output per hour worked, grew at a healthy 2.5% rate from the same quarter a year ago, but overall hourly compensation is up a steep 7.7%.
That means the labor cost of making a typical unit of output -- or unit labor cost -- rose 5% over the past year. That pace matches the peak reached in 2000, which was the fastest growth rate since 1990. Historically, unit labor costs have been a key driver of inflation, because speedups, like the current one, increase the pressure on companies to try to cover the added production cost by lifting prices.
THE QUESTION for the inflation outlook is this: To what extent are cost pressures pushing companies to lift their prices in order to support their bottom lines? The answer may not be clear for several more months, as more price data become available. In July, at least, inflation outside of energy and food looked tamer than in previous months. The Fed's preferred gauge rose only 0.1% from June, the smallest monthly gain this year.
Businesses without the pricing power to adjust can only watch as their profit margins shrink, and some bit of margin squeeze seems to be occurring. However, note that despite the surge in labor costs, earnings last quarter continued to grow strongly. Economywide corporate profits in the second quarter were up a hefty 20.5% from a year ago, the Commerce Dept. reported, the best showing in two years.
One problem is, recent data don't tell a consistent story. For example, a steep acceleration in unit labor costs accompanied at the same time by a speedup in corporate profits is difficult to reconcile. If costs are rising as rapidly as the data say they are, then it's a good bet profit margins of many businesses are getting squeezed. For example, the Sept. 6 report shows prices in the second quarter are up 3.3% from a year ago, far slower than the 5% rise in unit labor costs. It's possible current government data are overstating profits, but earnings reports from individual companies in the Standard & Poor's 500-stock index have been surprisingly robust as well, even excluding energy.
A growing trend that may be helping businesses to cope is the shift toward bonuses in lieu of pay raises, as noted in a recent survey of companies by the human resources firm Hewitt Associates (HEW). Bonuses, many of which are paid in the first quarter, may explain part of the 13.7% quarter-to-quarter surge in first-quarter compensation, measured at an annual rate. Greater use of variable pay, which ties pay to performance, limits a company's fixed labor costs, helping profitability and easing the need to lift prices.
BUT THERE'S ANOTHER, LESS BENIGN possibility: Overall demand may actually be stronger than the current numbers suggest. If so, many businesses will have more success pushing through price hikes in coming months. That's a premise worth considering, since the flip side of surging labor costs for businesses is greater income growth for working households.
Indeed, the labor markets generated far more income for workers in the first and second quarters than earlier data had shown. In the second quarter, the broadest measure of labor income, including straight pay and benefits, plus bonuses, stock options, and other forms of compensation, grew a revised 8.3% from a year ago. Earlier data had showed it growing an already handsome 6.8%. Labor income has grown more than twice as fast as inflation, which goes a long way toward explaining why consumer spending has been so resilient and why it should remain sturdy in the second half.
The 3.9% rise over the past year in hourly earnings for production and nonsupervisory workers has been eaten up by inflation, a fact much commented on. But the more important gauge for spending is overall income. For this group, about 80% of payrolls, income was up in August by 6.2% from a year ago, based on the combined pattern of both hourly pay and hours worked.
AGAINST THAT BACKDROP, the rebound of consumer spending shouldn't be surprising. In July, the broadest gauge of consumer purchases, adjusted for inflation, rose a healthy 0.5% from June . Even with no further rise in August and September, real spending for the quarter would still grow at an annual rate of 3.2% from the second quarter. That means consumers' contribution to economic growth this quarter will be up from last quarter's 2.6% increase.
Consumers also see good news at the gas pump. Gas prices have dropped in recent weeks, and lower wholesale prices promise further declines at the pump in coming weeks. The bulk of the decrease will show up in the September price indexes, which could result in an overall drop in the consumer price index.
Moreover, if gas prices stay down, the overall inflation rate will be much smaller in the fourth quarter than in the third quarter, just as the holiday buying season rolls around. Solid income growth and a smaller bite from overall inflation will give consumers' buying power a sizable boost.
What matters most, though, for the inflation outlook -- and for Fed policy -- is the trend in prices outside of energy. On that verdict the jury is still out, but the recent evidence from the labor markets on business costs and household income raise a red flag. The Fed noted in the minutes of its Aug. 8 meeting its wish "to accumulate more information before judging whether additional firming [in interest-rate policy] would be necessary." The danger is: While the Fed waits, the labor markets may already be generating new inflation pressures.
By James C. Cooper