The US labour market is adjusting to tighter monetary policy

The Federal Reserve has made it clear that in order to cut interest rates, it must see evidence that inflation is likely to reach and remain durably around 2%. In turn, that requires the rate of increase of prices in the large service sector to slow further. Services are labour intensive, so the evolution of labour costs is critical in judging the outlook for services prices.

This is one reason why the Fed is focused on labour market developments. The other reason is that it has as an explicit mandate to pursue “maximum employment.” In practice, it interprets this as the lowest level of unemployment that can be achieved without causing excessive wage growth.

To judge how tight the labour market is and the pressure on firms’ wage costs it is useful to look at the quit rate and the Employment Cost Index (ECI).

Employees quit their jobs when they have an outside job offer or when they think they are very likely to attract a new job offer. The quit rate can therefore be seen as a measure of the tightness of labour markets as perceived by workers.

The ECI measures the change in the hourly labour cost to employers and includes both the cost of wages and salaries and the cost of benefits. It is free from the effects of workers moving between occupations and industries.¹ Such changes are important.²

The graph below shows the quit rate and annual change in the ECI.³

Chart 1. Quits and the Employment Cost Index

Source: FRED and EFGAM calculations. Data as at 09 March 2024.

Changes in labour market conditions are reflected with a delay. We have therefore plotted the current rate of change of labour costs against the employment cost six months ago.

Two aspects of the graph are interesting. First, there is a close relationship between the two variables. Workers quit their jobs when labour markets are tight, and they think it is easy to find another job. These are also periods when labour costs are increasing as firms raise wages to attract workers.

Second, both series have been declining recently and, using the quit rate as a guide, it appears likely that employment costs will continue to fall in the coming months. Overall, the graph signals that the US labour market is in the process of adjusting to the Fed’s prior tightening of monetary policy. They key issues are how quickly and how far that adjustment process will go.

Since 2001, the average quit rate was 2.0%, the average rate of increase of the ECI 2.9% and the average rate of PCE core inflation 2.0%. At the end of the graph above, the quit rate had declined to 2.1% (in January 2024) and the growth rate of ECI had fallen to 4.2% (in December 2023).

This suggests that if the quit rate stabilised and the rate of increase of the ECI were to continue to fall for a few months, both these time series would be close to their historical averages, which were associated with inflation at the Fed’s objective. Thus, the US labour market may be close to being normalised.

¹ For more information, see https://go.pardot.com/e/931253/eci-home-htm/3zrwx/341961963/h/n8iff8knMEBQenu0fcO027xkmDZpqaUUjgKWNJYP9Vc
² Since younger, less well-educated workers and minorities are more exposed to the business cycle than other workers, they are disproportionally likely to lose their jobs in a downswing and regain them in a business cycle expansion. This tends to moderate swings in some measures of wage costs since they are paid less than other workers.
³ The total non-farm quit rate (series JTSQUR in FRED) and the ECI is that for Total compensation: All Civilian (series ECIALLCIV in FRED). Both series are seasonally adjusted. The latter series is quarterly; it has been rendered monthly by setting the value for all months in the quarter equal to the quarterly value.