Comment: Steady wage growth isn’t what Fed wanted to see

The thinking goes that earning power drives inflation and will force more interest rate increases.

By Jonathan Levin / Bloomberg Opinion

The Federal Reserve just got some bad news on the service sector, one of the last redoubts of stubbornly high inflation in the U.S. That’s fueling further speculation that interest rate increases may yet have a ways to go, and markets aren’t loving it.

Understandably so. A Labor Department report on Friday showed that average hourly earnings for private sector service-providing jobs rose 0.6 percent in November from the previous month, the fastest pace since October 2021. Annualizing the last three months of data, the numbers suggest a trend rate of service-wage inflation of about 6.2 percent, far too high for the Fed, which probably sees the sustainable non-inflationary rate sitting somewhere below 3.5 percent. Overall hourly earnings are climbing by slightly less, helped by goods-producing sectors, and nonfarm payroll growth slowed slightly to 263,000 jobs in November. But the service jobs are critical.

Why put the focus there? As Fed Chair Jerome Powell laid out in his speech this week, the service sector is probably the most vexing piece in the U.S. inflationary puzzle. The supply chain snarls that probably started the whole mess have shown strong signs of getting straightened out, and the prices of many goods and commodities have been falling. Forward-looking measures of housing rents, another key driver of the highest inflation in 40 years, are also hinting at moderation. But the other core services categories continue to challenge the Fed, and wages are probably a big part of that.

This may be the most important category for understanding the future evolution of core inflation. Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.

There’s a perverse element to cheering for weaker wage growth, which is generally associated with a soft labor market and higher unemployment. The idea of wage-price pass-through has many skeptics who note, correctly, that the current bout of inflation wasn’t caused by a tight labor market. Indeed, the decades that preceded the covid-19 pandemic spawned many smart critiques of the once-vaunted Phillips Curve, the economic model that has long undergirded the idea of a link between inflation and too-low unemployment.

But the late-pandemic economy was unique from earlier decades in the extreme labor shortages it created, and it’s logical to suspect that, for instance, there would be a direct line between the quickly rising wages of barbers and the cost of a haircut, or the earnings of hotel workers and the price of a vacation. Powell seems to feel the same way, judging from his speech on Wednesday. In the case of this month’s data, the service sector wage increases looked fairly broad based, including jumps in retail trade, professional services and a rebound in health and education services, which had recently been showing signs of cooling in the same data.

As always, it’s important to take Friday’s data with a grain of salt. The S&P 500 Index was down 1.1 percent, and the yield on 10-year Treasury bonds was up 9 basis points to 3.59 percent, but markets are essentially just snapping back from an otherwise ebullient November. Ultimately, it could take more than just this one report to shift the market’s mood, and the next big catalyst may not come until the consumer price index is reported on Dec. 13. It’s just one month of labor market data, and the Fed tends to favor the Labor Department’s employment cost index for a broad assessment of the compensation picture that’s adjusted for compositional effects. (The next update of that indicator won’t be released until late January next year, just before the Fed’s first rate decision of 2023.)

The data trail is also littered with some signs of hope. Only a day ago the Commerce Department reported that the core personal consumption expenditures deflator — the Fed’s preferred gauge of inflation — rose a relatively muted 0.2 percent in October, including a reasonable 0.3 percent increase in services excluding housing and energy. But with the Fed committed to preventing inflation from becoming entrenched, policymakers are likely to err on the side of doing too much rather than too little. Every time they get a piece of data like the wage gains, it only reinforces their will to stay the course.

Jonathan Levin has worked as a Bloomberg journalist in Latin America and the U.S., covering finance, markets and M&A. Most recently, he has served as the company’s Miami bureau chief. He is a CFA charterholder.

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