With US headline and core inflation remaining far above the Federal Reserve’s 2% objective, much attention is drawn to the recent surge in employment costs. But what factors determine how these have evolved and what is the relative importance of tight labour markets and high inflation? EFG Chief Economist Stefan Gerlach looks at the data.
Employment costs and the tightness of US labour markets
What drives employment costs? To study this question, we look at the Bureau of Labor Statistics Employment Cost Index (ECI). It captures employers’ costs for wages, salaries and a range of different benefits.
Employment costs were growing at between 3-4% between 2002 (when the data started) and the onset of the financial crisis in 2008. Thereafter, the growth rate of employment costs averaged between 1.5-3% until the second half of 2021, when the cost of labour started to rise rapidly.
The rise in employment costs reflects in part the tightness of labour markets. Traditionally, this has been measured by the unemployment rate. However, measures capturing both the number of unemployed and the number of job vacancies appear to contain more information about employment cost pressures.
One such variable is the ratio of vacancies to the number of unemployed workers (the V/U ratio). The V/U ratio plays a central role in the transmission of shocks to the labour market and to employment costs. The ratio moves together with employment costs in a striking manner. It slows after the Global Financial Crisis, then starts to rise gradually before declining sharply as Covid struck in 2020. Since then, it has risen sharply, peaked and started to decline.
The determination of employment costs: empirical evidence
In addition to the tightness of the labour market, much of the current debate about wage increases focuses on workers’ demands for compensation for past inflation. To consider the roles of the V/U ratio and PCE inflation in determining employment costs, we estimate a simple statistical model. The model enables us to compute how the growth rate (over four quarters) of employment costs responds to shocks to CPI inflation (also measured over four quarters) and the V/U ratio. Moreover, we can decompose employment costs into the parts due to the different shocks.
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