KEY DATA: ECI (Year-over-Year): 2.6%; Wages: 2.6%; Benefits: 2.7%/ Consumption: 0.4%; Disposable Income: 0.0%/ Claims: 262,000 (down 34,000)
IN A NUTSHELL: “Firms are hanging on to their workers and one of the ways they are doing that is by increasing compensation.”
WHAT IT MEANS: Yesterday we saw that the economy stalled in the first quarter. Was the slowdown a one-quarter wonder or whether it was a portent of more weakness to come? The telling data is income. Yes, personal income was flat in March, but the gains had been strong and there is every reason to think that they will get even better going forward. Adjusting for the size of the labor force, unemployment claims are at record low levels. Job openings are nearing record highs and I suspect we will see the numbers continue to rise all year. That is turning into rising costs for employers. The Employment Cost Index jumped again in the first quarter and most of that increase is coming from the private sector. Wages and salaries at companies rose by 2.8% rate over the year compared to 1.8% in the public sector. One year ago, the rise in private sector wages and salaries was only 1.7%, so it is quite clear that the labor shortages are hitting home. Indeed, during the last expansion, private sector wages rose at about a 2.9% pace, so we are just about at a normal rate of increase already – and the real impacts of the growing labor shortages have yet to hit. With incomes rising, it is likely that we will see continued solid increases in consumer spending that we got in March. Indeed, the somewhat modest consumption growth that we saw in yesterday’s first quarter GDP is not likely to be repeated this quarter or for quite a while.
MARKETS AND FED POLICY IMPLICATIONS: When will the Fed raise rates? Yesterday’s statement made it clear that it will do so “… when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term”. Read that sentence closely. To me, “further improvement” means additional declines in the unemployment rate and the number underemployed. The two, though, go together. Firms having trouble finding workers will eventually start hiring those that they didn’t want when there were plenty of job candidates. The necessary improvement could occur within the next few months, especially if the low claims and high openings numbers have any predictive value. As for inflation, the Fed will be watching not just consumer prices but employment costs. That is why today’s ECI is eye-opening. Private sector firms have been holding the line on wage increases yet we are already at normal rates of increases. Within a quarter or two at the most, we should be back above 3% and I suspect that will be a very clear red flag for the Fed. And let’s not forget benefits. They have been well contained but how long can firms continue to push benefits costs back on workers when they cannot get or keep employees? The conditions seem to be in place for labor costs to start breaking out on the upside, if they haven’t already, and that would be enough to provide the FOMC with the confidence that the inflation target will be reached, especially since the target is not right now but “over the medium term”.