What unit labor costs can tell us about where inflation is headed

This week is a big week for inflation data: The Labor Department is putting out its latest consumer price index on Wednesday, the producer price index comes out Thursday and the import price index comes out Friday.

Meanwhile, the Labor Department also released some revised productivity numbers this morning: How much stuff we made compared to how much time we spent making it. Productivity increased 2.2% in the third quarter, which is pretty strong by historical standards.

But another data point in the report, something called unit labor costs, was revised lower. And that can tell us a lot about where inflation is headed.

Think about unit labor costs as a ratio of how workers’ compensation compares to how productive they are. Put more simply?

“It’s just a straightforward way to compare how much we’re producing, relative to how much it costs to produce that, in labor terms,” said George Pearkes, macro strategist at Bespoke Investment Group.

He said it’s important to keep an eye on unit labor costs because if compensation is rising way faster than workers’ hourly output?

“What that means is workers have more cash to spend on goods and services. And businesses have to raise prices to account for that increase in labor costs,” he said.

In other words: more inflation.

Unit labor costs picked up a lot three years ago, back when labor was in really high demand and wages were spiking. 

But more recently?

“Wage growth has generally been slowing across a number of measures,” said Skanda Amarnath, executive director of the research group Employ America.

He said while wage growth has slowed down, worker productivity — you know, output per hour — has stayed strong.

“And so when productivity’s growing strongly, and wages are not growing quite as strongly as productivity, it will show up as unit labor costs slowing,” Amarnath said.

And that means businesses have fewer reasons to raise prices.

Gerald Cohen, chief economist at the Kenan Institute of Private Enterprise at the University of North Carolina, said labor costs are a huge part of what goes into making a good or providing a service.

And if labor costs are slowing down while businesses are getting more productive?

“The cost of what you produce is growing more slowly, and that means you don’t need to have big increases in prices to retain your profit margins,” he said.

In fact, Cohen said unit labor costs are growing at a slower rate than inflation, which can help cool off prices even further.

“And that’s kind of the holy grail of what we want. You have wage costs growing more slowly and so prices can grow more slowly, and so you have downward pressure on inflation,” he said.

And that could help the Federal Reserve finally bring inflation closer to its 2% target.