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The Cost of Labor as an Inflation Indicator

Economists consider a broad range of economic indicators to gauge inflationary pressures in the economy. One indicator of potential inflation pressure is the cost of labor. Higher labor costs, the theory suggests, means that firms may boost prices. In the Federal Reserve's semiannual Monetary Report to the Congress, Chairman Ben Bernanke noted that "[u]pward pressure on inflation could materialize if final demand were to exceed the underlying productive capacity of the economy for a sustained period" and that "[m]easures of labor compensation, though still growing at a moderate pace, have shown some signs of acceleration over the past year, likely in part the result of tight labor market conditions."

Turning to the data, labor compensation growth has risen over the past couple years from about 3 percent in mid-2004 to nearly 5 percent at the end of 2006. Moreover, labor productivity growth has moderated significantly from highs in 2002-2004 to roughly 2 percent. These two trends have pushed up unit labor cost growth substantially over the past couple of years, from about a 1-1/2 percent decline to about a 3 percent rise by the end of 2006.

Output and Compensation
Unit Labor Cost

However, Chairman Bernanke also noted that such "increases in compensation might be offset by higher labor productivity or absorbed by a narrowing of firms' profit margins rather than passed on to consumers in the form of higher prices."

It could be argued that the rising unit labor cost growth measure may exaggerate the potential inflationary pressure in the economy: Some question the labor compensation measure used to calculate unit labor costs because it does not control for shifts in industry and occupation structure, and it can be heavily influenced by variable and infrequent factors such as large bonus payments. Another labor cost measure, the Employment Cost Index (ECI), computes total compensation based on a fixed mixture of industries and occupations in order to distinguish labor cost growth from growth caused by shifts in industrial and occupational structure over time. It also includes many important elements of labor compensation, including benefits such as paid leave, bonuses, insurance, payroll taxes paid by employers, and retirement and savings benefits, which when combined, account for nearly 30 percent of total compensation. The ECI reveals a more sanguine labor compensation trend than the compensation measure used to calculate unit labor costs. It suggests that while compensation growth has inched up a bit over the past year, it has moderated since 2000.

Employment Cost Index

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