Wednesday, 17 of October of 2018

Economics. Explained.  

S&P 500 Stock Prices

May 8, 2018

The S&P fell 10% after reaching a record high level in late January.   It has since recovered some of the earlier losses and is now about 7.0% below its earlier peak level.  But this should be regarded as a normal stock market “correction” and not as a harbinger of economic weakness ahead.

The catalyst was average hourly earnings data for January which rose 2.9% in the previous 12 months.  That was the fastest growth in hourly earnings thus far in the business cycle.  So the fear at that time was that, at last the economy is overheating, inflation has begun to climb and, therefore, the Fed will raise rates more quickly than it has penciled in for 2018.  Since then the market has worried that tariffs imposed by President Trump will reduce growth of exports and slow the economy.  It worried for a time about worsening relations between the U.S. and North Korea.  The same is true between the U.S. and Russia.  It worried when the yield on the 10-year note reached the 3.0% mark.  The market has found a lot to worry about, but the reality is that the economic outlook remains bright.

The economy is likely to increase 2.8% this year which is faster than the 2.6% increase reported for 2017.  That will put some upward pressure on the inflation rate, but the question is how much pressure.  Our sense is that it will be modest with the core CPI rising 2.4 in 2018 versus 1.8% last year.  That is fairly close to the 2.0% Fed target for inflation and unlikely to spur it to raise rates more quickly.

It is important to remember that wage pressure can be offset by gains in productivity.  If I pay you 3% more money and you are no more productive, my labor costs just rose by 3.0% and I may well choose to raise my prices as a result.  But if I pay you 3% more money because you area 3% more productive and I am getting 3% more output, I do not care.  In that situation I have no incentive to raise prices.  Thus, the appropriate gauge of upward pressure on the inflation rate from the seemingly tight labor market is labor costs adjusted for the increase in productivity or what economists call “unit labor costs”.

In the past year unit labor costs have risen 1.1% consisting of a 2.5% increase in compensation partially offset by a 1.3% increase in productivity.  For 2018 we expect labor costs to climb to 3.5%, but given the burst of investment spending (which is the primary determinant of growth in productivity) we expect productivity growth to climb to 1.5%.  Hence, unit labor costs this year should rise by 2.0%.  A 2.0% increase in unit labor costs will not put upward pressure on the Fed’s 2.0% inflation target.

People are watching the wrong thing.  They are watching average hourly earnings when they should be watching unit labor costs.  If it begins to climb to 2.5-3.0% then we have a legitimate chance of inflation climbing above the Fed’s 2.0% inflation target.  We are not expected to get there any time soon.

Stephen Slifer


Charleston, SC

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