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No Direct Correlation Between Rising Labor Costs and Inflation, Says SF Fed Study

A recent Federal Reserve Bank of San Francisco analysis dispels the common perception of labor costs directly influencing inflation.

Federal Reserve Bank of San Francisco
Federal Reserve Bank of San Francisco

Labor Costs and Inflation: A Myth?

A recent announcement from researchers at the Federal Reserve Bank of San Francisco (SF Fed) on Tuesday shed new light on the relationship between rising labor costs and inflation. Contrary to widely held beliefs, the study suggests that wage increases do not significantly contribute to heightened price pressures, potentially undermining long-standing arguments in economic debates.

Analyzing Labor Costs: The Employment Cost Index

In the latest edition of the FRBSF Economic Letter, Adam Shapiro conducted an analysis showing negligible effects of labor costs on goods or housing services inflation, as measured by the Employment Cost Index (ECI). His research indicates that ECI only accounts for a small fraction of non-housing services inflation. The ECI, having surged from 2021 to 2022, coinciding with the rise in inflation, is considered the most comprehensive U.S. measure of labor costs and is closely monitored by Federal Reserve policymakers.

The State of Inflation and ECI

According to the study, the ECI peaked mid-2022 at about 5.1% and eased to a 4.8% annual rate in the first quarter. Meanwhile, inflation, as measured by the Fed's favored gauge, peaked at roughly 7% last year and, as of April, was maintaining a rate of 4.4%, more than double the Fed's 2% target.

The Surprising Relationship Between ECI and Inflation

Shapiro's analysis further disclosed an interesting observation: the recent surge in the ECI only explains a minute fraction (one-tenth of a percentage point) of the three-percentage-point rise in the underlying inflation during the same period. This insight led Shapiro to suggest an alternative interpretation of the dynamics between wages and inflation. Instead of wages driving inflation, the reverse could be true: wages might follow inflation. This finding emphasizes the critical need to reassess current understandings of labor-cost dynamics about inflation.