Fed is looking at sharply rising labor costs

Federal Reserve Board Chairwoman Janet Yellen.
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Federal Reserve Board Chairwoman Janet Yellen.

In the first three quarters of this year, hourly compensations in the U.S. nonfarm business sector rose at a rate of 3.1 percent, about three times the pace of advance observed in 2013. Over the same period, unit labor costs accelerated to an annual rate of 2.1 percent from 0.25 percent. [Unit labor costs are a difference between wages and labor productivity. They are usually thought of as a floor below the country's inflation rate.]

This sharply rising price of labor since the beginning of the year is caused by an increasing demand for labor services, as the jobless rate declined by nearly a full percentage point and the number of unemployed fell by 1.2 million.

Will this evidence move the Fed to begin its process of "normalizing" interest rates?

It should. But if that is not enough, here are a few more issues to show that the U.S. monetary policy may soon have to begin its long journey toward a neutral position.

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The first thing to note is that a sustained increase in hourly compensations is signaling rising demand-supply imbalances in U.S. labor markets. Since last August, for example, the recorded unemployment rate has been steadily moving below its structural level of 6.1 percent, reaching 5.8 percent in October.

That structural unemployment rate is based on the long-term trend growth of the economy (aka "potential growth rate"). Its more complicated technical names are "non-accelerating inflation rate of unemployment (NAIRU)" and a "full employment unemployment rate."

Hitting the speed limits?

Put more simply, October's 5.8 percent unemployment rate implies that the U.S. economy is operating above its non-inflationary potential, and that it is beginning to hit its physical limits (in terms of labor and capital) to growth.

It certainly looks that way. America's 2.3 percent economic growth in the first three quarters of this year is 0.4 percentage point above the potential growth rate of 1.9 percent estimated during the post-crisis period from 2009 to (and including) 2013.

Capacity strains in the U.S. economy look much stronger if the growth potential is approximated as a sum of growth rates of labor supply and labor productivity over the same five-year period. That gives a potential growth rate of 1.56 percent and indicates that the U.S. economy is now running 0.74 percentage point (2.3-1.56) above its non-inflationary growth capacity.

Now, one can quibble – and many people do – about the various estimates of the potential growth rate of the U.S. economy. It is, however, difficult to argue with the fact that a steady increase in the U.S. labor demand has been pushing up wage costs in the first nine months of this year. The numbers for that period show that the labor productivity growth doubled from the same interval of 2013, but that still could not prevent accelerating unit labor costs.

What lies ahead?

Riding on growing jobs and incomes, and easy credit conditions, the U.S. economy is poised to maintain its forward momentum in the coming months. Under these circumstances, businesses will have little difficulty in passing their rising labor costs on to consumers to protect their profit margins.

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I am sure the Fed is well aware of these risks to price stability.

The problem, as always, is to act in time to prevent rising inflation expectations when – as is the case now -- the headline inflation indicators still look relatively well behaved.

Fed's speed: How fast from 0.08% to 4%?

But the Fed cannot stay put until signs of gathering price pressures can no longer be ignored. If it did that, the Fed would quickly find itself well behind the curve and unable to avoid the next round of the inflation-recession cycle.

The reason is simple: Fed's actions are subject to long and variable lags, because it can take anywhere from three to five quarters for interest rate changes to begin affecting the real economy.

And here is the first stretch of the distance the Fed's policy change will have to travel.

At the close of trading last Friday, the effective federal funds rate was at 0.08 percent, roughly what it was a year ago, and well below the official target of 0.25 percent. Making a heroic assumption that the U.S. inflation will remain at about 2 percent for the foreseeable future, the Fed would have to bring the federal funds rate close to 4 percent – just to keep its policy stance neutral, i.e., neither tight nor loose.

So, how soon will the Fed begin to move in that direction?

I believe the first steps could come much sooner than the middle or latter half of next year the markets currently expect.

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As I wrote in an earlier column, last August marked a turning point in the Fed's money supply decisions. Since then, the monetary base shrank by $203.9 billion (that is 25 percent of the Fed's pre-crisis balance sheet), and its current annual growth has been cut to 5 percent from 19 percent during the third quarter.

That was a quick piece of work.

Investment thoughts

Accelerating unit labor costs is a signal the Fed is unlikely to ignore. Rapid and large withdrawals of excess liquidity are also a sign that the Fed is acting more decisively than aficionados of the "forward guidance" seem to be expecting.

Fixed-income assets remain crossed out in my book. At this point, a careful review of equity portfolios would be a good idea. Prospects of a tightening monetary policy always suggest defensive investment postures.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.