Labor Costs, Inflation Expectations, and the Affordable Care Act: What Businesses Are Telling Us

The Atlanta Fed’s May survey of businesses showed little overall concern about near-term inflation. Year-ahead unit cost expectations averaged 2 percent, down a tenth from April and on par with business inflation expectations at this time last year.

OK, we’re going to guess this observation doesn’t exactly knock you off your chair. But here’s something we’ve been keeping an eye on that you might find interesting. When we ask firms about what role, if any, labor costs are likely to play in their prices over the next 12 months, an increasing proportion have been telling us they see a potential for upward price pressure coming from labor costs (see the chart).

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To investigate further, we posed a special question to our Business Inflation Expectations (BIE) panel regarding their expectations for compensation growth over the next 12 months: “Projecting ahead over the next 12 months, by roughly what percentage do you expect your firm’s average compensation per worker (including benefits) to change?”

We got a pretty large range of responses, but on average, firms told us they expect average compensation growth—including benefits—of 2.8 percent. That’s about a percent higher than the average over the past year (as estimated by either the index of compensation per hour or the employment cost index). But a 2.8 percent rise is also about a percentage point below average compensation growth before the recession. We’re included to read the survey as a confirmation that labor markets are improving and expected to improve further over the coming year. But we’re not inclined to interpret the survey data as an indication that the labor market is nearing full employment.

We’ve also been hearing more lately about the potential for the Affordable Care Act (ACA) to have a significant influence on labor costs and, presumably, to provide some upward price pressure. Indeed, several of our panelists commented on their concern about the influence of the ACA when they completed their May BIE survey. So can we tie any of this expected compensation growth to the ACA, a significant share of which is scheduled to go into effect eight months from now?

Because a disproportionate impact from the ACA will fall on firms that employ 50 or more workers, we separated our panel into firms with 50 or more employees, and those employing fewer than 50 workers. What we see is that average expected compensation growth is the same for the bigger employers and smaller employers. Moreover, the big firms in our sample report the same inflation expectation as the smaller firms.

But the data reveal that the bigger firms are a little more uncertain about their unit cost projections for the year ahead. OK, it’s not a big difference, but it is statistically significant. So while their cost and compensation expectations are not yet being affected by the prospect of the ACA, the act might be influencing their uncertainty about those potential costs.

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By Mike Bryan, vice president and senior economist,

Brent Meyer, economist, and

Nicholas Parker, senior economic research analyst, all in the Atlanta Fed’s research department

Labor Force Participation and the Unemployment Threshold

On Friday, my colleague Julie Hotchkiss shared in this space the results of her new research (with Fernando Rios-Avila, a Georgia State University colleague) on the recent and prospective behavior of the labor force participation rate (LFPR). The punch line, from my point of view, is this:

Our results suggest that relative to the average LFPR over the years 2010–12, the average LFPR over the years 2015–17 will rise by about a third of a percentage point—again, if the labor market returns to prerecession conditions. (Italics original)

As Julie notes:

[T]he Federal Open Market Committee has substantially raised the stakes on disentangling...movements in labor force participation...by introducing into its policy deliberations concepts like unemployment thresholds and qualitative assessments on "substantial" labor market improvement.

Though the meaning of "substantial labor market improvement"—a condition for adjusting the FOMC's current large-scale asset purchase program—is somewhat ambiguous, the unemployment threshold for considering moving the federal funds rate off the near-zero mark is less so. As the Committee indicated in its May press release:

[T]he Committee decided to keep the target range for the federal funds rate at 0 to ¼ percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6½ percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

It is widely understood (a sign of the times, no doubt) that changes in the unemployment rate are not entirely independent of what is happening with the participation rate. We have discussed this issue before here in macroblog. But in light of the new research coming from our own shop (and other research cited in Julie's post), it seems like a good time for a refresher.

First, a step back. Multiple upward revisions to the employment situation since the December jobs report—you can follow the trail courtesy of Calculated Risk here, here, here, here, and here—have led to a more robust picture of the labor market than certainly I was thinking. Here is what the record looks like for most of the recovery:

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With an assist from the Atlanta Fed Jobs Calculator, we can provide further perspective on these numbers. In particular, under the assumption that the labor force participation rate will remain at its current level of 63.3 percent (among other things held constant), we can map the recent job growth numbers to a rough date when the unemployment rate will reach 6½ percent.

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That looks interesting, but then taking the Hotchkiss and Rios-Avila research onboard means the assumption of a constant labor force participation rate may not be justified. So, turning again to the Jobs Calculator, the following table answers this question: If we continue on the 208,000-per-month pace of job creation of the last six months, and the labor force participation rate is X, what would the unemployment rate be by June of next year? For reference, the first row of the table replicates the earlier result under the assumption that the participation rate will maintain its current level; the second row takes into account the Hotchkiss and Rios-Avila research; and the third assumes an even larger bounce back in participation:

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It is probably worth noting that the full increase in the Hotchkiss and Rios-Avila estimates happens in the 2015–17 timeframe, raising the interesting possibility that the threshold for considering interest rate increases could occur sometime before the unemployment rate moves back above the threshold.

Also, it is not at all obvious that rising labor force participation would necessarily arrive along with a rising unemployment rate. From 1996 through 1999, for example, the participation rate rose by nearly by 0.7 percentage point (the difference between the rates in the first and third rows in the table above), even as the unemployment rate fell by just over 1½ percentage points. The key was the strong employment growth over that period—almost 260,000 payroll jobs per month on average.

All of that, as should be clear by now, embeds a whole bunch of assumptions, which may make this the most important part of the FOMC's decision criteria:

In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions...

By Dave Altig, executive vice president and research director of the Atlanta Fed

Behavior’s Place in the Labor Force Participation Rate Debate

It's not often that the mainstream media is interested in the nuances of labor market statistics, so last week’s debate over the meaning of labor force participation rates (LFPR) in the pages of the Washington Post and the Wall Street Journal was music to this labor economist's ears.

Sparked by an article by Ben Casselman in his April 29 Wall Street Journal Outlook column, the ensuing back and forth (here, here, here, and here) between Casselman and the Post’s Jim Tankersley focused on what has become a central preoccupation in assessing the likely course of the labor market: Is the recent decline in the labor force participation rate the result of structural factors (e.g., an aging population) or cyclical ones (such as weak economic conditions)? Almost contemporaneously, Bill McBride declared in his recent Calculated Risk blog, "…most of the [recent] decline in the participation rate was due to changing demographics...as opposed to economic weakness."

The changing pattern of labor force participation has been a topic of discussion among economists for some time—for example, see my Federal Reserve Bank of Atlanta Economic Review article—and both Tankersley and Casselman agree that the long-run secular decline in participation is a matter worthy of independent concern. But the Federal Open Market Committee has substantially raised the stakes on disentangling longer-run trends from short-run cyclical (and presumably temporary) movements in labor force participation. It’s done this by introducing into its policy deliberations concepts like unemployment thresholds and qualitative assessments on “substantial” labor market improvement.

Casselman, in an October 2012 WSJ article, cites work by my colleagues at the Chicago Fed, who find that while more than two-thirds of the decline in LFPR between 1999 and 2011 is accounted for by changes in the age distribution of the population, "…over the 2008-2011 period...only one-quarter of the...decline of actual LFPR...can be attributed to demographic factors."

This conclusion—that three-quarters of the decline in the LFPR since the beginning of the Great Recession can be attributed to cyclical factors—is supported by other research. Colleagues at the Kansas City Fed and at the Board of Governors concur that the vast majority of the decline in the LFPR since 2008 is the result of cyclical factors. Even economists outside the Federal Reserve System acknowledge the significant role of cyclical factors in the LFPR decline (for example, see the analysis by economists at the Deutsche Bank).

But there is a critical third piece to the LFPR puzzle that most of these studies ignore. In addition to changing demographics (which have, for example, been associated with a rising share of retirement-age individuals in the total population) and cyclical effects (for example, the tendency for participation to fall when wage growth is tepid or job opportunities scarce), there are also behavioral changes afoot—a point Casselman makes in his final installment of the Post/WSJ debate. For example, individuals of near-retirement age may extend their participation as a result of significant, unexpected declines in wealth. Or women with young children—a demographic group typically less likely to participate in the labor market—may increase participation if a partner loses a job during an economic downturn. In both cases, participation rates for these demographic groups would not fall by as much as expected in response to high unemployment rates alone.

Work that I've done with Fernando Rios-Avila, a colleague at Georgia State University, finds that more than 100 percent of the fall in the LFPR since 2008 is accounted for by the condition of the labor market (cyclical factors), but these particularly strong cyclical forces were countered by increased tendencies to participate (behavioral changes). In other words, if individuals hadn't stepped up to the plate and exhibited even stronger labor force participation behavior than before the recession, the LFPR would be even lower than it is.

To illustrate the role that changing behavior played in the LFPR decline during the Great Recession, the chart below illustrates how this decline can be separated into a trend component (demographics), a cyclical component (strength of the labor market), and a behavioral component. The solid black line reflects the actual LFPR in March of each year calculated using the Current Population Survey, which is the survey data used by the U.S. Bureau of Labor Statistics to calculate the monthly labor force statistics. The orange line reflects the trend estimate of the LFPR using only demographic data (such as the age distribution of the population) through 2007, projecting out to 2012. As many others have pointed out, changing demographics—the aging of the baby-boom generations, if you will—explains only about 30 percent (in this example) of the actual post-2007 decline in LFPR.

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But the chart also reveals something that may be underappreciated. Including a measure of labor market conditions in the projection of the LFPR, as well as a depiction of prerecession behavior (the green line), indicates that the LFPR should be much lower than it actually is. The message from this exercise is that the actual LFPR in 2012 was above what would have been projected had each demographic group exhibited the same labor force participation behavior after the recession as before the recession.

As it turns out, women, ethnic minorities, older people, and individuals with small children were much more likely to participate in the labor market after the recession than before it. These workers are often referred to as "added workers," or workers who join the labor force to make up for lost income elsewhere in the household. As I noted above, if these demographic groups had not increased their participation in the labor force, the aggregate LFPR would be much lower than it is.

What the chart tells us is that the cyclical factors affecting labor force participation are even more important than generally imagined. However, it is also true that the inevitable march of time will continue to put powerful downward pressure on labor force participation. Indeed, our research predicts only a modest rise in the LFPR if labor markets rebound to prerecession conditions. Our results suggest that relative to the the average LFPR over the years 2010–12, the average LFPR over the years 2015–17 will rise by about a third of a percentage point—again, if the labor market returns to prerecession conditions. Though higher than today, this level would still leave the LFPR considerably lower than it was before the recession, primarily reflecting the continued downward pressures of aging baby boomers.

By Julie Hotchkiss, a research economist and policy adviser in the Atlanta Fed’s research department

Weighing In on the Recent Discrepancy in the Inflation Statistics

Recently, there has been a divergence between inflation as measured by the Consumer Price Index (CPI) and the preferred inflation measure of the Federal Open Market Committee (FOMC), which is the price index for personal consumption expenditures (PCE). That divergence is fairly evident in the “core” measures of these two price statistics shown in the chart below.

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This strikes us (and others, like Reuters’ Pedro da Costa) as a pretty significant development. The core CPI is telling us that the underlying inflation trend is still holding reasonably close to the FOMC’s longer-term target of 2 percent. But the behavior of the core PCE is rather reminiscent of 2010, when the inflation statistics slid to uncomfortably low levels—a contributing factor to the FOMC’s adoption of QE2. Which of these inflation statistics are we to believe?

Part of the divergence between the two inflation measures is due to rents. Rents are rising at a good pace right now, and since it’s pretty clear that the CPI over-weights their influence, we might be inclined to dismiss some part of the CPI’s more elevated signal. But then there are all those “non-market” components that have been pulling the PCE inflation measure lower—and these aren’t in the CPI. These are components of the PCE price index for which there are no clearly observable transaction prices. They include the “cost” of services provided to households by nonprofit organizations, or the benefits households receive that can only be imputed (i.e., that “free” checking account your bank provides if you maintain a high balance.) Since we can’t really observe the price of these things, we’d probably be inclined to dismiss their influence on PCE the inflation measure. But we’ve done the math, and the impact of these two influences accounts for only about a third of the recent gap between the core PCE and the core CPI inflation measures. Most of the disagreement between the two inflation estimates is coming from elsewhere.

We could continue to parse, item by item, all the various components and weights of the two statistics to get to the bottom of this discrepancy. But in the end, such an accounting exercise would merely tell us why the gap between the two measures has emerged, not which measure is giving the best signal of emerging inflation trends.

As an alternative approach, we thought we’d let the data speak for themselves and search for a common trend that runs through the detailed price data. What we have in mind is to compute the “first principal component” of the disaggregated data used to calculate the CPI and the PCE price indexes. The first principal component is a weighting of the data that explains as much of the data variation as possible. So, in effect, the detailed price data in each price index are being reweighted in a way that reveals their most commonly shared trend, and not by their share of consumer expenditure.

The chart below shows the 12-month trend of the first principal component derived from the 45 CPI components used in the computation of the Federal Reserve Bank of Cleveland’s median CPI, and the first principal component derived from the 177 components used in the computation of the Federal Reserve Bank of Dallas’s trimmed-mean PCE. (These are the most detailed component price data we could easily get our hands on.)

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So what do we make of this picture? Well, three things:

First, inflation as measured by the PCE price index has tended to track about 0.25 percentage point under inflation as measured by the CPI over time. So part of the gap between the two inflation measures appears to be a long-term feature of the two inflation statistics.

Second, the first principal components of both the CPI and the PCE data have been persistently under their precrisis averages. In the case of the PCE measure, the first principal component is under the FOMC’s 2 percent target (a point that has not gone unnoticed by Paul Krugman).

A third takeaway from the chart is that the “disinflation” pattern traced out by these principal components has been gradual and modest—much more so than what the core PCE has recently indicated and what the data were telling us back in 2010.

Does that mean we should ignore the recent disinflation being exhibited in the core PCE inflation measure? Well, let’s put it this way: If you’re a glass-half-full sort, we’d say that the recent disinflation trend exhibited by the PCE price index doesn’t seem to be “woven” into the detailed price data, and it certainly doesn’t look like what we saw in 2010. But to you glass-half-empty types, we’d also point out that getting the inflation trend up to 2 percent is proving to be a curiously difficult task.

By Mike Bryan, vice president and senior economist,

Pat Higgins, economist,

Brent Meyer, economist, and

Nicholas Parker, senior economic research analyst, all in the Atlanta Fed’s research department