Wage growth slows as Fed set to ease up on rate hikes

Wages and benefits rose at a slower rate during the final three months of 2022, according to data released Tuesday, giving the Federal Reserve room to ease up its fight against inflation.

The Labor Department’s Employment Cost Index (ECI), which tracks increases in wage and benefits costs for employers, rose 1 percent for non-military employees during the fourth quarter, slightly lower than economists expected. It was the smallest gain in the ECI since the fourth quarter of 2021.

The Fed pays close attention to the index as a sign of how much a strong labor market is driving inflation. The year-end slowdown in wage and compensation growth could give the Fed more confidence to keep slowing down — and eventually stop — its series of aggressive rate hikes. 

“A downshift in ECI wage growth in Q4 would not immediately stop Fed officials talking about their intention to raise rates further. But their tone likely will soften, and such data would make it more difficult for them to continue hiking after this week,” Ian Shepherdson, chief economist at Pantheon Macroeconomics, wrote in a Tuesday analysis.

The Fed is all but certain to announce an interest rate hike of 0.25 percentage points Wednesday, even with wage growth slowing. Fed officials have been reluctant to declare victory against inflation despite five consecutive months of falling price growth, with both inflation and wage gains still at swift levels.

Wages and benefits rose a whopping 5.1 percent on the whole in 2022, according to the Labor Department, which is well above levels the Fed sees as sustainable.

“The pace of wage growth is a key determinant of inflation across an array of services,” Shepherdson wrote.

“We concur with the argument that inflation will rebound back above the target, no matter how far it falls over the next year, if wage growth cannot be contained at a sub-4% rate.”

Wages have risen rapidly since the early days of the recovery from the COVID-19 recession and accelerated as the combination of effective vaccines and pent-up demand unleashed a tidal wave of consumer spending.

Many businesses were soon overloaded with customer orders, but found it difficult to hire workers for open gigs from a much smaller pool of candidates. Workers were also quick to leave their current employers and industries for gigs with better pay, compensation and career opportunities.

Tim Jankowski, president of Aladdin’s Cleaning & Restoration in Lapeer, Mich., said his company has leaned into employee development to help retain workers and help them achieve higher wages.

“To initially attract talent, we have to provide good entry-level wages, which has certainly made it more expensive to onboard new employees,” Jankowski said in an email.

“But once we packaged everything together, we found that new hires upskilled quickly into new positions within the company.”

Other firms have curbed some of their options to maximize their ability to serve customers at a decent price point.

Stacy Elmore, co-founder of the Indianapolis-based Luxury Pergola, said in an email that her company moved away from custom outdoor home fittings and toward kit products “to move more volume at a lower price, and save money on labor per project.”

“Retaining employees has come down to involving them more in the decision making of the business and increasing pay to be a leader in our area, for our industry, in terms of pay and benefits,” she added.

The Fed is hoping to see wage growth continue to slow to levels that won’t push some businesses into raising prices, a key force behind the recent bout of high inflation. A steady decline in both wage and price pressures may allow the bank to taper out its rate hikes before the second half of the year.

Some economists and investors believe the Fed has already ramped up rates enough to bring inflation and wage growth down and fear further hikes will drive the U.S. into a recession. The Fed is projected to hike rates by another 75 basis points before the end of the year barring a major shift in the economy.

“The quarterly rate of wage growth slowed more significantly in industries that are disproportionately affected by softer consumer demand. Wage growth in retail trade, leisure and hospitality, and professional and business services declined substantially in the second half of 2022,” Sinem Buber, lead economist at ZipRecruiter, wrote in a Tuesday analysis.

Updated at 3:42 p.m.