Employment cost index undershoots expectations; Labour costs likely peaked

on Jan 31, 2023
  • The Employment cost index underperformed market expectations in Q42022.
  • Government employees saw steep falls across all categories over the quarter ending December 2022.
  • In light of this data, the Fed is likely to assume a lower rate pathway and may pause in Q1 2023.

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The Federal Funds Rate is arguably the most powerful economic instrument at the disposal of policymakers.

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Despite the accelerated tightening in 2022, the unemployment rate has stayed at historic lows while nonfarm payrolls have proved robust, denting the Fed’s efforts to contain inflation.

Source: US BLS

After being pushed into an uncomfortable corner thanks to the unimaginable surge in inflation last year, the Federal Reserve seems to be just beginning to wrestle back some semblance of control.

Addressing employee costs is now considered to be the most vital requirement for the Fed, given that services are dominating inflation concerns today.

In BLS’s December jobs report (which interested readers can view here), wage growth did decline, falling to 4.6% in December 2022, well below market expectations.

Source: US BLS

However, the FOMC has been reluctant to commit to a monetary pathway until there is clear evidence that employee inflation has begun to durably ease.

Many economists expect that if wage growth were to fall to roughly 3.5%, the Fed would be able to guide the economy towards its 2% PCE target.

Employment cost index

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The employment-cost index (ECI), is a measure of what employers pay as wages and benefits to workers.

It is often considered the gold standard of labour market cost measures and was the last key inflation indicator to be published before the FOMC’s meeting.

Larry Summers, Former United States Secretary of the Treasury noted the importance of this report,

…wages are a kind of a supercore inflation…that will be a very revealing number.

ECI for civilian workers

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For the quarter ending December, the ECI increased by 1%, undershooting market expectations of 1.1%.

The measure also eased from 1.2% recorded in the Q3 2022 report.

The softness in the ECI indicates durable wage disinflation, and combined with the recent jobs report suggests that employee costs have truly peaked.

The slowdown is the assurance FOMC members were looking for regarding the deceleration in wage growth and has likely greenlit a lower rates trajectory.

On an annual basis, compensation costs rose by 5.1%, significantly higher than the previous increase of 4%.

This increase during 2022 was in response to the surge in wages and benefits paid due to the hiring frenzy and increased competition for workers earlier in the year.

Source: US BLS

Wages and benefits for civilian workers

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The indexes for wages and benefits were in line with market forecasts (as reported by TradingEconomics.com) at 1.0% and 0.8%, respectively.

Wages eased from 1.3% in Q3, marking the lowest quarterly rise throughout 2022.

On an annual basis, the wage index increased by 5.1% compared to 4.5% in the corresponding quarter of the previous year.

The increase in benefits over 12 months remained unchanged from Q3 2022 to Q4 2022 at 4.9%, which was well above Q4 2021 at 2.8%.

Private sector

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In the private sector, quarterly compensation and wages both eased to 1.0%, from 1.1% and 1.2%, respectively in Q3.

Benefits also eased from 0.8% to 0.7% from the earlier quarter.

State and local governments

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During the quarter, state and local governments saw a sharp decline in all three categories, with compensation, wages and benefits each falling to 1.0%, down from 1.9%, 2.1%, and 1.6%, respectively.

Alternative indications of weakness in the labour market

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The softening in the employment cost data seemed to confirm indications that job market strength may be overstated.

For instance, the unemployment rate was likely to be artificially suppressed due to the exit of millions of workers since the pandemic, as well as the low labour participation rate.

Perhaps more importantly, over 400,000 full-time jobs have been lost since May 2022, only to be replaced by a surge in part-time roles and other gigs.

Most recently, 35,000 temporary workers were laid off in December 2022, foreshadowing the unravelling of the broader labour market.

Fed expectations

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After the Fed eased rate hikes to 50-bps during the December meeting (which you can read about here), the financial markets have strongly anticipated that monetary authorities will temper the pace of tightening to the traditional 25-bps during the February 1 announcement.

In the 20 minutes prior to the release, the CME FedWatch Tool, a measure of the probability of the magnitude of rate changes by the FOMC, registered a nearly unanimous 99.1% likelihood of a 25-bps hike.

The market’s conviction of the Fed’s intended direction has been cemented post the release, with a 98.9% calculated likelihood of a 25-bps in the upcoming meeting.

The remaining 1.1% signalled that the Fed would pause rate hikes immediately, as compared to a 0.9% likelihood of a 50-bps hike before the publication.  

The Fed is almost certain to raise rates by 25-bps tomorrow, while there is potential for pausing in the March meeting, depending on the release of fresh employment and wage growth data.


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