Fed Chairman Ben Bernanke has recently enjoyed some days when the data release du jour supported his view that a slowing economy would lessen inflationary pressures. Yesterday wasn’t one of those days.
The Labor Department on Wednesday revised the pace of labor costs in the second quarter to 4.9% from the earlier 4.2% estimate. What makes the increase notable is that the same report also revised upward the output per hour for the nonfarm sector (also known as a measure of productivity) to 1.6% from 1.1%. “Usually, this would get translated directly into an equal sized downward revision to unit labor costs, but the GDP report also included unusually larger upward revisions to labor
compensation during the first six months of this year,” wrote David Resler, chief economist at Nomura Securities in New York, in a note sent to clients yesterday.
For some dismal scientists, the trend in labor costs is worrisome as it relates to inflation’s outlook. “You have a very pronounced acceleration in [unit labor costs] and the people at the Fed who are concerned about entrenched inflation will regard this as a very grave development,” Pierre Ellis, senior economist at Decision Economics in New York,told Reuters.
Another economist echoed that view in an interview with Bloomberg News: “Of all the economic data out there right now, labor costs are sending the strongest warning signal on inflation,” said Ethan Harris, chief U.S. economist at Lehman Brothers Holdings. “I don’t think the Fed can dismiss this.”
The bond market took the hint and sold off again yesterday, elevating the yield on the 10-year Treasury to back above 4.8% for the first time since August 29. Stocks followed, with the S&P 500 falling 1% on the day yesterday.
Adding to the notion that the economy may not go quietly into retreat, and thereby give the Fed the freedom to cease and desist with future interest rate hikes, was yesterday’s news that the service portion of the economy remains strong. The ISM Non-Manufacturing survey for August showed that the services sector, which accounts for about two-thirds of the economy, picked up its pace of growth last month vs. July.
Meanwhile, this morning’s latest on weekly jobless claims reveals a drop in the number of people filing for unemployment benefits for the week through September 2 to the lowest level since late July.
If this looks like compelling evidence to some that the economic soil is still fertile for elevating pricing power, not everyone agrees. If inflation is again the new new worry, why did gold, the historic inflation hedge, tumble yesterday? Meanwhile, traders in Fed funds futures still expect Bernanke and company to hold steady on interest rates next week when the FOMC meets. The October Fed funds futures contract remains serenely unchanged in the wake of yesterday’s news.
We’re all still data dependent, as Mr. Bernanke likes to say, but the data’s still singing more than one tune. David Kotok of Cumberland Advisors identified the central challenge this morning in an email to clients:

My good friend and fishing partner, Wachovia’s Chief Economist John Silvia, summed it up succinctly this morning. He said: “The challenge with Unit Labor Costs is that we don’t know how much is going to come out of profits and how much will go into inflation.”