Schwab Guide to Economic Indicators: Unit Labor Costs

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Schwab Guide to Economic Indicators: Unit Labor Costs
by the Schwab Center for Financial Research
November 30, 2007

What is it?
It’s a wage-inflation indicator that compares compensation to output.

Unit labor cost figures are provided for the following on a quarterly basis:

business (excludes general government, nonprofit institutions and private households)
nonfarm business (excludes general government, nonprofit institutions, private households and farming)
manufacturing

durable goods
nondurable goods

nonfinancial corporate (excludes general government, nonprofit institutions, private households, farming, unincorporated business, and those corporations classified as offices of bank holding companies, offices of other holding companies, or offices in the finance and insurance sector)

The nonfarm business category of unit labor costs is the most widely-watched of these and is the indicator journalists and publications typically reference.

The report is produced quarterly by the Bureau of Labor Statistics (BLS) using data provided by the Bureau of Economic Analysis (BEA), BLS and the Federal Reserve.

What is its relative importance?
High. It’s widely followed because of its impact on inflation. In general, all costs associated with labor represent roughly two-thirds of the price of finished goods and services; however, this impact can vary widely by industry. The unit labor costs index is one of several key indicators monitored by the Federal Reserve as it sets monetary policy.

What impact does it have on the market?
The degree to which a unit labor costs index meets expectations is typically one of the most influential aspects of the report.

Bond prices typically fall (yields rise) in reaction to higher-than-expected unit labor costs readings because this measure of wage inflation has the potential to spillover into other traditional prices indexes. This reaction can be more pronounced when the economy is growing near or above its potential because that’s when it’s more susceptible to allowing inflation pressures to become imbedded. Stock prices may also fall.

Why?

A rise in bond yields can eventually make bonds more attractive once the fall in bond prices settles down. Compared to where the weights of stocks and bonds were in your portfolio, the typical thing to do in response to this change in valuation would be to sell a portion of your stock portfolio and put the proceeds into bonds.

Alternatively, if unit labor costs become subdued, this can give a boost to stock and bond prices. Low growth rates of unit labor costs help reduce inflation pressure while potentially increasing corporate profits, thereby supporting stocks.

How is it calculated?
The unit labor costs figure is derived by comparing compensation to output.

According to the BLS, “Compensation is a measure of the cost to the employer of securing the services of labor. It includes wages and salaries (like shift differentials, all kinds of paid leave, bonus and incentive payments, and employee discounts), and employer contributions to employee-benefit plans (like medical and life insurance, workmen’s compensation, and unemployment insurance).”

Output, or the value of finished goods and services, is adjusted for price change. Inter-industry transactions are excluded to avoid double-counting. “For example, the output of the steel industry is excluded to the extent that it is incorporated in final products such as automobiles,” the BLS said. An index is created for the resulting output figure.

To obtain unit labor costs, the compensation index is divided by the output index. It’s computed on a seasonally adjusted basis.

The BLS presents the quarterly data as:

an index number series with the base value set at 100 for the year 1992
percent changes from the corresponding quarter of the previous year
percent changes from the previous quarter presented at a compound annual rate

How is it used?
The breakdown of the index's construction helps the Fed to more wisely manage monetary policy.

As previously defined, to calculate unit labor costs, a compensation index is divided by an output index. In this case, compensation is just a dollar figure not a dollar-per-hour figure. However, if a dollar-per-hour figure is used, it opens up another helpful way for understanding hourly wages. In this representation, the dollar-per-hour figure is referred to as hourly compensation. When it’s compared to (divided by) productivity, it mathematically produces the same unit labor cost figure as found with the more simplified calculation.

Why is this helpful? This latter methodology provides a constructive way to evaluate hourly compensation. For example, if hourly compensation is rising, it’s not necessarily inflationary if it’s proportionally matched or exceeded by a rise in productivity. Conversely, subdued hourly compensation readings could surprisingly be inflationary if productivity is proportionally more subdued than hourly compensation.

Note: unit labor costs is a lagging indicator. Rises in the index today are usually the result of too much economic stimulus several months prior. That stimulus can come in the form of accommodative (low) interest rate policy by the Fed. At some point within this segment of the business cycle, the Fed begins to raise short-term interest rates. Once the cumulative amount of rate hikes is finally considered restrictive, it can take roughly six months for economic growth to begin to slow. However, it can take approximately six more months for inflation readings, such as unit labor costs, to begin to subside.

Conversely, decreases in unit labor costs are usually the result of too much economic restraint several months prior. At some point within this segment of the business cycle, the Fed begins to cut short-term interest rates. Once the cumulative amount of rate cuts is finally considered stimulative, it can take roughly six months for economic growth to begin to increase and another six months for unit labor costs to begin to rise.

The lag times described in these examples are general in nature. They can vary from one business cycle to the next.

Explanation regarding the accuracy of nonfarm business unit labor costs
Despite the attention received by the nonfarm business unit labor costs index, it’s not the most accurate data series. The BLS admits that “data and other resources available for their preparation somewhat limit the productivity, output, compensation, and employment measures which can be constructed. In several sectors where output is difficult to define in a satisfactory way, productivity measures are correspondingly weak. Examples are the construction industry and the financial services sector.” The BLS warns, “The productivity and costs measures for these sectors should be interpreted with caution.”

To get away from those sectors and help solve this accuracy problem, the Fed gives greater emphasis to the nonfinancial corporate data series. While it’s considered more reliable, it takes nearly an extra month to produce. It’s released along with the first revision. See below.

When is it released?
The BLS releases the unit labor costs report approximately 35-to-40 calendar days after the close of the quarter, with the first revision released after an additional 30 days. You can find it on the BLS home page for productivity under the Economic News Releases section, labeled Productivity and Costs.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

(2007-5771)

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