Hot Wage Growth Highlights Lingering Inflation Risks

The major indices finished at or near new highs last week despite the Federal Reserve throwing cold water on chances for a widely anticipated rate cut in March. While Federal Reserve Chairman Jerome Powell pointedly noted that the Fed was unlikely to adjust rates at its next meeting, the Fed’s statement released after the latest Federal Open Markets Committee meeting struck a softer tone on the path forward. Specifically, language referencing the potential for additional rate hikes was removed, signaling the Fed believes the next time it makes an adjustment to rates, it will be to lower them. However, a variety of employment data out last week threw the timing for any potential cut into question.

While the slew of employment readings painted a contradictory picture, one number stood out and highlighted the risk the Fed faces as it tries to determine the right time to ease monetary policy. The latest wage data found in the Bureau of Labor Statistics (BLS) Nonfarm Payroll report shows private nonfarm wages increased 0.6 percent in January, double December’s pace of 0.3 percent. On a year-over-year basis, nonfarm wages are up 4.5 percent. Wage growth for production and non-supervisory employees—a group we believe provides a more relevant view of wages—rose by 0.44 percent, up from December’s pace of 0.37 percent. On a year-over-year basis, nonsupervisory and production wages are up 4.8 percent—well above the 3 to 3.5 percent pace the Fed believes is consistent with its target of 2 percent inflation. While the difference in the current pace of wage growth and what the Fed views it needs to be to meet the inflation rate target may seem small, a look at recent earnings data from the S&P 500 highlights the significant impact of elevated wages.

With nearly half of the companies in the S&P 500 having reported quarterly earnings, revenue for the quarter is up 3.3 percent year over year—well below the pace of wage growth. That means to maintain profit margins companies will either be forced to raise prices (inflation) or cut costs, which could include laying off workers. Either approach would be at odds with the Federal Reserve’s dual mandate of promoting maximum employment and price stability. While it is possible that a marked influx of new workers could ease the strain of the tight labor situation, we believe it is unlikely. The latest BLS data shows that the labor participation rate remains stuck at 62.5 percent in January, unchanged from the prior month and down from a recent high of 62.8 in November. As we’ve noted in the past, given the aging demographics of the U.S., we believe it is unlikely we will see a sustained uptick in labor participation and instead expect the workforce to grow by between 50,000 and 90,000 workers per month. Our view is shared by the non-partisan Congressional Budget Office and the BLS, which have both forecast a shrinking labor force participation rate in the coming years.

The other way we could see continued economic growth without additional inflationary pressure is through a spike in productivity levels. Here, too, the data is messy. According to the latest numbers from the BLS, labor productivity increased by 3.2 percent year over year in the fourth quarter of 2023 compared to 2.7 percent year over year in the fourth quarter of 2022. For all of 2023, productivity grew at an annual rate of 1.2 percent. While the last three quarters have seen strong productivity gains, we believe they are an offset to the slow gains and, during some quarters, productivity decreases experienced throughout much of the post-COVID period. Our view is shared by Chairman Powell, who noted in his comments last week that he does not expect a meaningful uptick in the rate of productivity in the near term.

With labor participation unlikely to materially increase from current levels and productivity gains potentially returning to historic norms, we believe the Fed will be slow to cut rates aggressively until it sees wages ease for an extended period or net job losses in the economy. Our view is consistent with Chairman Powell’s oft stated stance that the Fed is data dependent and will act only after it has seen convincing evidence over an extended period of time. This approach was evident in its response to inflation in the immediate aftermath of the arrival of COVID. Instead of acting quickly and raising rates in 2021, the Fed let the process play out and didn’t make its first rate hike until March of 2022. We highlight the Fed’s slow reaction to early price pressures not as criticism but as an indication that, in our view, it will hold rates steady for longer than many investors expect as it waits for a clearer picture that wages are no longer a threat to its progress in bringing inflation down. Unfortunately, given the lagging nature of the employment market, this may result in the Fed not cutting rates until a cooling of the economy has already gained momentum. Should that occur, we expect the Fed may need to make larger cuts to right the economy and prevent a mild downturn from becoming more serious.

Wall Street wrap

While wage data out last week painted a clear threat to the Fed’s mandate for price stability, other employment data provided a mixed view, which could complicate the timing of potential rate cuts in the future.

Mixed signals for the job market: The nonfarm payroll report for January showed that hiring increased, with 353,000 new positions added, up from December’s revised reading of 333,000 and well above Wall Street estimates of 185,000. Of the added positions, 317,000 were in the private sector, up from December’s 278,000 private-sector hires. Hiring broadened, with 65.6 percent of industries hiring, up from a recent low of 52.4 percent in November. To be sure, these numbers will be revised in coming months, as they represent estimates based on seasonal adjustments; however, the trend in the employment market has been strong, with an average of 289,000 jobs added each month over the past three months, up from the six-month average of 248,000.

While the headline number of the Nonfarm report captured investors’ attention, the so-called Household report offered a different take. This report is used to calculate the unemployment rate and uses a different approach of measuring the job market by counting the number of people employed. The latest Household survey showed a decrease of 31,000 employees in January from the prior month. For further context, the report showed the economy lost 683,000 employees in December. Over the past three months, the Household report has registered average declines of 43,000, and on a six-month basis, average job losses were 10,000. The Household and Nonfarm numbers occasionally diverge in the short to intermediate term; however, during the past six months, the Nonfarm report has shown 1.489 million new jobs added, while the Household report registered a 57,000 decline in the number of employees. Over the past 12 months, there has been a disparity of 1.927 million jobs. From 1956 through the arrival of COVID, the disparity between the two numbers on a six-month basis has never reached this level, and the 12-month disparity has been eclipsed in only four months going back to 1956. The gap between the two numbers may be influenced by the economic anomalies created by COVID, but it still may prompt the Federal Reserve to wait for a clearer picture to emerge before taking further action on rates. While we believe the two readings will eventually converge, other measures suggest that the labor market may begin to show signs of weakness in the coming months. For example, layoff announcements are beginning to increase. According to last week’s report from Challenger, Gray and Christmas Outplacement Services, January saw 82,300 announced job cuts, up 136 percent from December’s level of 34,817. While still below January 2022’s level of 103,000, it is worth noting that hiring has dried up, according to the survey, with just 5,736 new hires announced, marking the lowest January number on record of the survey. The January figure comes on the heels of December’s reading of 3,022, which marked the lowest monthly total in the report’s history going back to 2004.

Jobless claims rise: Weekly initial jobless claims numbered 224,000, an increase of 9,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 207,750, up 5,250 from the prior week. Continuing claims (those people remaining on unemployment benefits) were at 1.898 million, an increase of 75,000 from the previous week. The four-week moving average for continuing claims rose slightly to 1.841 million, down 7,500 from last week’s revised figure but still up 14 percent from year-ago levels. The magnitude of the increase from year-ago levels is consistent with increases that coincided with the arrival of the past seven recessions.

Job openings decline but outpace available workers: The BLS Job Openings and Labor Turnover Survey released earlier last week showed the number of job openings came in at 9 million in December, an increase of 101,000 from November’s total. The so-called “quits” rate, which is viewed as a proxy for the level of confidence employees feel about the job market, came in at 2.2 percent, unchanged from November’s rate and tied for the lowest level since September 2020.

Manufacturing continues to contract but shows signs of life: The latest data from the Institute for Supply Management (ISM) shows the manufacturing sector extended its streak of contractionary readings to a 15th consecutive month with a reading of 49.1, up two points from December’s level. Signs of growth remain muted, with just four of the 18 industries included in the survey reporting expansion. Readings for new orders came in at 52.5, up 5.5 points from December and the highest level since May 2022. Customer inventories declined to 43.7 (which indicates inventories are too low), down from December’s reading of 46.2. The decline in the inventory reading may bode well for future productivity. Backlog orders declined to 44.7. It’s worth noting that as orders broke into expansionary territory, so did prices paid—with the latest reading coming in at 52.9, up 7.7 points from December and the highest level since April 2023.

Despite the uptick in activity, the employment index stayed in contractionary territory at 47.1, down modestly from 47.5 in the prior month. Importantly, in the latest release, Tim Fiore, chair of the ISM, noted, “Panelists’ companies maintained production levels month over month and continued headcount reductions in January, with significant layoff activity.” We will be watching to see if the uptick in manufacturing has legs and, if so, whether it will lead to greater demand for workers.

Consumers feeling bullish: Consumer confidence rose in January, and forward expectations edged higher. The Conference Board’s consumer confidence index rose to 114.8 in January, up from the prior month’s revised reading of 108. The expectations index, which measures consumers’ short-term outlook for income, business and labor market conditions, came in at 83.8, up from November’s reading of 81.9. As a reminder, readings below 80 on the expectations index have typically coincided with the arrival of a recession in the coming 12 months. The readings over the past two months show a marked improvement in optimism as consumers react to lower inflation and expectations that interest rates will decline.

As a part of the index, the Conference Board measures how easy or difficult respondents find it to land a job. In January, those saying it’s hard to get a job fell to 9.8 percent, down from 13.1 percent the prior month. Meanwhile, those who viewed jobs as plentiful jumped to 45.5, up from December’s level of 40.4. The gap between those who find it hard or easy to get a job is the labor differential, something we’ve been tracking closely due to our belief that the employment picture is the remaining key to bringing inflation sustainably down to 2 percent. December’s labor differential came in at 35.7, well above December’s revised reading of 27.3. This measure is considered a leading indicator of the labor market. The differential had been shrinking throughout much of 2023, but the recent uptick suggests the labor market remains tight and may make it difficult for employers to restrain the pace of wage growth in coming months.

The week ahead

Monday: The ISM releases its latest Purchasing Managers Services Index. Recent readings have shown growth in the sector slowing, and we will watch for any signs of additional weakening.

We’ll get the latest results from the Federal Reserve’s Senior Loan Officer Opinion Survey in the afternoon. The past few surveys have shown tightening lending standards at large and mid-sized banks. We will be watching for signs of further tightening as well as the state of loan demand. Results from this report will take on additional significance, as regional banks came back into focus last week when New York Community Bank slashed its dividend and materially increased its loan loss reserves in anticipation of potential loan losses in its office and multi-family real estate portfolio.

Wednesday: The Federal Reserve will release its latest look at the financial condition of consumers through its Consumer Credit report. Consumers have begun to take on more credit card debt in recent months, but overall balance sheets have remained solid. We will be watching for changes in debt levels now that the financial cushion many consumers built during COVID has been depleted.  

Thursday: Initial and continuing jobless claims will be announced before the market opens. Initial filings rose last week, and the four-week rolling average of continuing claims declined. We will continue to monitor this report for signs of changes in the strength of the employment picture.

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