3% Is The New 2%
ECI came in as expected. The Employment Cost Index (ECI) released today came in as (we) expected and it implies that underlying inflation is around 3%. There is no surprise at all. Disinflating the US economy will take time and requires help from either (or both) sides of the Beveridge curve. The new run of the model is included in this note.
The incoming data
According to the BLS, over the three months ending in September, total compensation for private industry workers increased 4.1% QoQ (a.r.) and 4.3 percent YoY. Wages and salaries increased 4.5 percent for the 12-month period ending in September 2023, while benefit costs increased 3.9 percent.
Why we trust this model
There is a Phillips curve. Despite what many claim, the ECI Phillips curve model has consistently delivered good forecasts. For instance, if we take as a reference the YoY of ECI (private industry workers) for 2023:Q4, the model delivered a 4.3% forecast back in October 2022 (see here (!)). It then confirmed the 4.3% forecast in April 2023 (see here), and marginally down to 4.2% in July 2023 (see here). The latest run of the model (see next paragraph) remained at 4.2%. Despite the critiques, is there a model that can deliver such accurate forecast 4 to 6 quarters ahead? We doubt it. Long life to the Phillips curve.
Our model-based forecast
The inclusion of the third quarter in the sample resulted in a forecast little changed. Figure 1 (right panel) shows a comparison between the current forecast, the published figures, and the previous forecast (our previous ECI notes are here (Jan ’23), here (Apr ’23), and here (Jul ’23). The published YoY at 4.3% in 2023:Q2 is just 3bps below the forecast made by the model back in June.
The YoY of ECI total compensation for private industry workers continues to be projected at 4.2 percent in 2023:Q4. The 2024:Q4 and 2025:Q4 forecasts (at 3.7 percent and 3.4 percent, respectively) are a bit higher than in June because, following the Fed staff forecast, the path of the unemployment rate is lower and the upper pressure on wage growth from the labor market is higher.
Figure 1. Phillips curve model-based ECI forecast
Current forecast, model-based
Comparison: current vs. previous forecast (QoQ and YoY)
Note: the figure shows the ECI Phillips curve model-based forecast (YoY). The chart refers to the year-over-year percent changes of compensation costs for private industry workers. The confidence intervals are based on the estimated parameters distributions. The table on the right shows a comparison between the current forecast (2023:Q3 last quarter in-sample) and the previous forecast (real-time in 2023:Q2).
An heterodox Phillips curve
An heterodox Phillips curve continues to suggest there is no free lunch: wage growth disinflates when labor market cools off. Figure 2 shows what can be labeled as “an heterodox Phillips curve”. The figure shows the relation between ECI total compensation growth and an ad-hoc measure of “slack”: the difference between the unemployment rate and the jobs opening rate. The idea is that we remain agnostic about the current slope of the Beveridge curve. While it is unclear what side of the Beveridge curve will dominate going forward, a convincing disinflation that brings ECI growth to about 3% requires our measure of “slack” to be around 0. This means that we have at least another 1 to 1.5pp of disinflation to achieve, either side of the Beveridge curve, before wage growth can return to a level consistent with the Fed target. The good news is that there is no mystery through the lens of this “heterodox” Phillips curve: ECI growth is where it should be.
Figure 2. An heterodox ECI Phillips curve.
Conclusion
Underlying inflation around 3%. Today’s data imply that “underlying inflation” as defined by Fed staff is around 3%. This should not come as a surprise because this is perfectly in line with our estimates at 2.7% (see here). Right now, “3% is the new 2%”, there is little doubt.