March 5, 2020
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 rose 0.9% in the fourth quarter. compared to an increase of 0.2% in the third quarter. The fourth quarter quarter consists of a 2.1% increase in compensation combined with a 1.2% increase in productivity. During the past year unit labor costs have risen 1.7%.
Looking ahead we expect compensation to increase by 3.8% in 2020 given the tightness in the labor market. We expect productivity growth to climb by 1.7%. Hence unit labor costs should increase 2.1% in 2020. If wage pressures (adjusted for the increase in productivity) are going to increase 2.1% in 2020, the inflation rate is likely to climb to the Fed’s 2.0% inflation target.