Upward Trending Labor Costs May Have a Far Greater Impact on Inflation Than Recent Headlines on Energy Costs

Monday, March 28th, 2016
By Charles McNally, Chief Portfolio Strategist, Manifold Fund Advisors

With wholesale energy prices reaching a 5-year low in early 2016, it is little wonder that inflation protection became a back-burner consideration for many advisors. However, trends in labor costs could be the signs of a different inflation story.

When the Consumer Price Index (CPI) rose 1.4% from January 2015 to January 2016, the jump in year-over-year inflation rates from nearly zero for most of last year was seen as a shot across the bow. The recent February CPI release brought the annual rate back down to 1.0%, but the report gave little reason for complacency despite headline figures that were well short of the Federal Reserve’s (Fed’s) 2% inflation target.1

The ‘core’ CPI, which does not include food and energy, has been running at higher rates (2.2% in January and 2.3% February), largely because the core rate has escaped the gravitational pull of falling energy prices. Constituting about 7% of the CPI basket, energy prices have a visible and direct influence on the full CPI. However, although commodity price changes and other “fast” data may have the most noticeable relationship with headline inflation, they do not necessarily have the greatest impact.

Other actively traded commodities have little impact in comparison to energy. Commodities provide the raw materials for the goods that are considered in the CPI basket—finished goods. Stated another way, the index considers the cost of a new shirt, not the price of cotton. Even food commodities traded on future exchanges are processed before they are purchased; the consumer buys a loaf of bread, not the grain directly.

The key here is that the cost of processing, packaging, transporting and selling goods is typically far greater than the original commodity’s cost. Thus, service plays a significant role in the cost of goods, and consequently, changes in labor costs affect the end price of every finished good in the CPI basket.

Graph 1: Year-over-year rates of change for CPI (“headline inflation”) and Unit Labor Costs


Source: Bloomberg L.P.; U.S. Bureau of Labor Statistics

Furthermore, goods are less than half of the CPI; the greater part is services, such as shelter, medical care and transportation. Commodities have little influence on the cost of providing most services, but labor costs heavily influence the end-cost of both services and goods, even if this “slow” data is not noticed immediately.

Changes in consumer prices and labor costs can help to predict one another,2 and the relationship between labor costs and inflation is telling when comparing indexes. Since peaking in the early 1980s, the slowing pace of increase in labor costs correlates well with a similar slowdown trend in inflation (graph 1). The annual rates of change in core commodity prices, however, do not (graph 2).

Graph 2: Year over year rates of change in S&P GSCI and CPI


Source: Bloomberg L.P.

Across the country and in national presidential campaigns there is increasing discussion regarding labor costs. Advocates for higher minimum (“liveable”) wages have been promoting their agenda at both the government and private levels, with some success.

Several large corporations have announced plans to increase their minimum pay, one of the most recent being Costco (March 3),3 and larger compensation increases have been reported lately in negotiated labor settlements. With the unemployment rate falling below 5% early this year for the first time since 2008, labor markets appear to be showing signs of tightness. Though inflation growth has been sluggish, higher minimum wage and lower unemployment have the potential to influence an increase in unit labor costs, which could boost inflation.

Despite financial markets’ fascination with “fast” data such as commodity price changes, investors who may be impacted by inflation are better served to follow developments in the “slow” data of labor costs.

1 The Fed’s inflation target is measured by a related but slightly broader measure of personal consumption expenditures, the Personal Consumption Expenditures Price Index (PCE Price Index, or PCE).

2 David A. Brauer. “Do Rising Labor Costs Trigger Higher Inflation?” Current Issues in Economics and Finance 3, no. 11 (Sept 1997): 1, accessed March 14, 2016. https://www.newyorkfed.org/medialibrary/media/research/current_issues/ci3-11.pdf

3 Sarah Nassauer, “Costco to Raise Its Minimum Wage: Workers will begin making at least $13 an hour this month,” Wall Street Journal, Mar 3, 2016. Accessed March 8, 2016. http://www.wsj.com/articles/costco-to-raise-its-minimum-wage-1457031421.

Important Disclosures

CPI – Consumer Price Index (CPI) is a measure used to assess price changes associated with the cost of living complied by the Bureau of Labor Statistics.

PCE – Personal Consumption Expenditures (PCE) is the primary measure of consumer spending on goods and services in the U.S. economy. It accounts for about two-thirds of domestic final spending.

S&P GSCI® Index – The widely tracked S&P GSCI® is recognized as a leading measure of general price movements and inflation in the world economy. The index – representing market beta – is world-production weighted. It is designed to be investable by including the most liquid commodity futures, and provides diversification with low correlations to other asset classes. The index does not incur fees and expenses and is not available for purchase.

The views and opinions expressed in this article are those of the author and may differ from those of Manifold Fund Advisors, LLC and are for informational purposes only and not for the purpose of providing investment advice, are those as of the date of the article and are subject to change over time or at any time. Investors should review with their advisors the appropriateness of any investment strategy. Manifold Fund Advisors, LLC makes no guarantees on the completeness or accuracy of information provided herein.

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