IE 11 is not supported. For an optimal experience visit our site on another browser.

Why the Fed is closely tracking this number

The employment cost index is a low-key piece of data — but in recent months it has strongly influenced policy decisions at the Federal Reserve.
Image: A "Now Hiring" sign at a McDonald's restaurant in Yorba Linda, Calif, offers pay starting at $15 an hour on Sept. 13, 2021.
A "Now Hiring" sign at a McDonald's restaurant in Yorba Linda, Calif, offers pay starting at $15 an hour on Sept. 13, 2021.Jeff Gritchen / Orange County Register via Getty Images

The American economy wrapped up 2021 on an inauspicious note: Inflation notched another once-in-a-generation high, consumer spending took an omicron hit and employers’ costs to keep people on the payroll continued to climb. 

A key question for the Federal Reserve as it tries to tamp down rising prices is whether or not inflation is creeping into pay rates. This can create what economists call a wage-price spiral — an economically dangerous feedback loop that can push inflation uncontrollably high. 

The Employment Cost Index released on Friday found that employers’ compensation costs rose by 4 percent on a year-to-year basis, the highest level in two decades. Private-sector wages grew by 1.2 percent for the quarter — the equivalent of a 5 percent annual increase, which roughly tracks with other measures of wage growth. The most recent employment report from the Bureau of Labor Statistics found that, as of December, annualized average hourly earnings climbed by 4.7 percent. 

For the first time in decades, wages for those lower down the earnings ladder are increasing at a much more rapid rate than high earners.

“I think inflation will continue to be an issue throughout 2022, given the backdrop of labor shortages, which is both a good news and a bad news story,” said Joseph Heider, president of Cirrus Wealth Management. “What we’re seeing for the first time in decades statistically is folks on the bottom, the lower-wage income earners, are increasing at a much more rapid rate right now than high earners.”

The flip side is that the weight of inflation is borne unequally: Those lower-wage workers are already seeing their recent gains subsumed by higher prices, and people on fixed incomes don’t benefit at all from elevated wages, even while their expenses climb.

Policymakers at the Fed and elsewhere also use the personal consumption expenditures (PCE) price index as a key yardstick for measuring inflation. So-called core PCE backs out food and energy prices — which are volatile enough on a month-to-month basis that they can distort the bigger picture. For December, the broader PCE jumped by 5.8 percent on a year-over-year basis. Core PCE rose by 4.9 percent, the highest since 1983. Other commonly-used inflation measures include the consumer price index (CPI) and producer price index (PPI), both of which have also jumped. The CPI data released earlier this month showed the increase in prices at a 40-year high. 

“I think you’re going to continue to see inflationary pressures for the remainder of this year and probably into early 2023,” Heider said, pointing to stubborn supply chain bottlenecks as a primary cause.

“As one supply chain problem is solved, it’s likely we’ll see them somewhere else. It’s also being compounded right now because of geopolitical issues,” he said, noting that the heightened threat of conflict between Russia and Ukraine is pushing energy prices higher.

There are some indications that Americans might be growing more cautious in their consumption. Consumer spending fell by roughly half a percentage point in December. Economists attributed the 0.6 percent drop in the PCE to a confluence of factors including disruption to usual economic activity caused by the omicron variant of Covid spreading throughout the U.S. and an earlier holiday shopping season. 

The silver lining, to the extent that there is one, is that markets don’t expect these blistering-hot numbers to last very long — provided the American consumer can hang on. The University of Michigan’s Surveys of Consumer Sentiment found that optimism plunged in the first month of 2022, with sentiment hitting its lowest level since November 2011. 

Inflation is real and people are feeling it on a day to day basis. When does the consumer give up?

“If you look at breakeven inflation, which is a measure of inflation expectations… that’s actually down a little bit. Markets are viewing this as temporary,” said Melissa Brown, managing director of applied research at Qontigo, a financial intelligence firm. 

“The Fed is certainly trying to do something about it. I think the pain is obviously real now for the average American,” she said. “Let’s hope policymakers have it right.” 

“The next two months are projected to be even worse,” said Sam Stovall, chief investment strategist at CFRA Research. “We see CPI, PPI and PCE posting their peak readings in February before beginning their slide,” he said, predicting that CPI will top out at an annualized 7.3 percent before retreating. 

The Surveys of Consumers chief economist Richard Curtin noted that, while the initial supply and price shocks were triggered by Covid, the factors influencing how Americans today feel about the economy and their expectations have taken on a life of their own — a dynamic that poses a threat and a challenge to policymakers. 

“Consumers may misinterpret the Fed’s policy moves to slow the economy as part of the problem rather than part of the solution. The danger is that consumers may overreact to these tiny nudges, especially given the uncertainties about the coronavirus and other heightened geopolitical risks,” he said in his report accompanying the survey data.  

“I still think the consumer is in good shape and I think the consumer is willing to spend money… but clearly that can’t last forever,” said Will Rhind, CEO and founder of GraniteShares. 

“Inflation is real and people are feeling it on a day to day basis,” he said. “When does the consumer give up?”