SF Fed, Report: How Much Do Labor Costs Drive Inflation?

“Analysis in this Letter shows that labor-cost growth has a small effect on non-housing services (NHS) inflation, as well as inflation overall. The estimates imply that the recent surge in the employment cost index explains only about 0.1 percentage point (pp) of current elevated inflation readings, a negligible portion of the 3pp increase in the core PCE measure. Further analysis shows that changes in labor costs affect prices mainly through the supply channel. That is, the analysis shows businesses tend to raise prices when wages rise because their costs increase, not because demand increases.”

“The results cast some doubt on the narrative that labor-cost growth is by itself an important driver of NHS price inflation. This leaves open other explanations for the high correlation between labor-cost growth and inflation. For instance, recent evidence shows that wage growth tends to follow inflation, as well as expectations of future inflation (Glick, Leduc, and Pepper 2022). Overall, the results highlight that recent labor-cost growth is likely to be a poor gauge of risks to the inflation outlook.”