Labor Costs and Inflation

March 09, 2011 | Mike Spychalski, CAIA, Vice President

With the recent surge in commodity prices and inflationary pressures beginning to take hold in many emerging market countries, inflation has once again become a major topic of discussion in the United States. This week’s Chart of the Week shows the percentage changes in the Consumer Price Index and Unit Labor Costs since 1950. As the chart illustrates, over the past 60 years, there has been a very strong correlation of 0.825 between changes in labor costs and changes in inflation (a correlation of 0 indicates there is no correlation and a correlation of 1 indicates a perfect correlation).

Given the strong correlation between labor costs and inflation, it makes sense to look at current labor market conditions to get a more accurate picture of the inflationary pressures currently affecting the United States. The U.S. currently has an unemployment rate of 8.9% and an underemployment rate of 15.9% (the underemployment consists of the unemployment rate plus individuals working part time who would prefer full time employment and individuals who are not working or actively seeking a job but would want to have a job.) In addition, capacity utilization is currently 76.1%, which is well below its historic average of 80%, and worker productivity, which increased at a rate of 2.6% in the fourth quarter of 2010, has been steadily increasing over the past several years. The amount of slack currently built up in the labor market makes it very unlikely that the U.S. will see significant upward pressure on labor costs in the near term. This makes it unlikely that the U.S. will see significant upward pressure on inflation in the near term.