Wednesday, 22 of May of 2019

Economics. Explained.  

Unit Labor Costs

May 2, 2019

Unit labor costs might be a term that is not familiar to you.  Unit labor costs represent the increase in compensation adjusted for the gains in productivity.  You might think that if labor costs are rising that would put upward pressure on inflation.    It does not matter so much what wages are doing, but what wages adjusted for the change in productivity is doing.  Think of it this way.  If I pay you 3% more money, on the surface you might think that my costs as a businessman have just gone up by 3%.  That is not quite true.  What if you are 3% more productive?  Then I am getting 3% more output from you, so I really do not care.  I am very happy to pay you 3% more money.  In this case, unit labor costs, or labor costs adjusted for the gain in productivity, are 0%.  To take the example one step farther, if I pay you 3% higher wages but you are no more productive, then unit labor costs are rising by 3% and I am probably going to raise my prices to offset the higher cost of labor.  So, a gain of that magnitude in unit labor costs is quite likely to exert upward pressure on inflation.  So always watch what is happening to unit labor costs and not just wages.

Unit labor costs declined 0.9% in the first quarter after having risen 2,5% in the fourth quarter.  The first quarter increase consists of a 2.6% increase in compensation more than offset by a 3.6% increase in productivity.  During the past year unit labor costs have risen 0.1%.  The labor market is seemingly very tight and typically would generate some upward pressure on wages.  But if most of those wage gains are being offset by faster growth in productivity, then the upward pressure on the inflation rate from the labor market — is surprisingly low.  If unit labor costs are rising 0.1% and the Fed has a 2.0% inflation target, there is going to be no upward pressure on the inflation rate for sure even though the labor market is tight , and perhaps even some downward pressure on inflation .

Looking ahead  we expect compensation to increase by 3.4% in 2019 given the tightness in the labor market.  But we also expect productivity growth to climb by 2.3%.  Hence unit labor costs should increase 1.1% in 2018.  If wage pressures (adjusted for the increase in productivity) are going to increase 1.1% this year, that is entirely consistent with the Fed’s 2.0% inflation target or perhaps something lower.  Don’t worry about the sharp pickup in compensation to the 3.4% mark because much of that gain should be offset by faster growth in productivity.   Workers have earned their fatter paychecks.

Stephen Slifer


Charleston, SC

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