Thursday, 22 of February of 2018

Economics. Explained.  

S&P 500 Stock Prices

February 6, 2018

The S&P has fallen about 8.5% since reaching the latest record high level in late January.   But this should be regarded as a stock market event not an economic event.

The catalyst was average hourly earnings data for January which have now risen 2.9% in the past year.  That is the fastest growth in hourly earnings thus far in the business cycle.  So the fear is that, at last the economy is overheating, inflation has begun to climb and, therefore, the Fed will raise rates more than the three times than it has penciled in for 2018.

The economy is likely to increase about 2.9% this year which is faster than the 2.5% 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 2.2 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 1.3% consisting of a 2.4% increase in productivity partially offset by a 1.1% increase in productivity.  For 2018 we expect labor costs to climb to 3.0%, but given the burst of investment spending (which is the primary determinant of growth in productivity) we expect productivity growth to climb to 1.8%.  Hence, unit labor costs this year should rise by 1.2% which is virtually identical to what it was last year.  A 1.2% 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 even close.

Stephen Slifer


Charleston, SC

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