Academic journal article Economic Review - Federal Reserve Bank of Kansas City

A Closer Look at the Employment Cost Index

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

A Closer Look at the Employment Cost Index

Article excerpt

Labor costs have recently come under scrutiny by policymakers, business economists, and financial market participants. The primary concern has been that tight labor markets might lead to faster compensation growth and, ultimately, to upward pressure on general inflation. The employment cost index (ECI) has received particularly close attention because many analysts consider it to be one of the best measures of labor cost inflation. Other analysts, however, have questioned whether the ECI and other labor cost measures are useful in inflation forecasting. One reason for doubting the ECI's inflation forecasting value is that a moderate upward trend in ECI growth over the last three years has, so far, not been matched by a rise in the general inflation rate.

But economic analysts may have other reasons than inflation forecasting for using the ECI. Detailed information on employment cost trends may help analyze labor market developments and, indirectly, may reflect broader economic trends outside the labor market. In addition, companies may find the ECI useful in wage setting and other compensation decisions. Given the high profile that the index has sometimes assumed in the business press and financial markets, it is time to take a closer look at the ECI and evaluate its possible uses.

The first section of this article compares the ECI with other labor cost measures and concludes that it is the best measure for many, but not all, purposes. The second section shows that existing studies do not demonstrate a reliable predictive relationship between labor cost inflation and general inflation, suggesting the ECI should be monitored but may not deserve the close attention that it has sometimes received. The third section argues the ECI is quite useful in analyzing broader economic trends, such as the shift in jobs toward the service sector, and in business decisions about employee compensation. The article concludes that the ECI is more useful for labor market analysis and wage setting than for general inflation forecasting.

I. MEASURING EMPLOYMENT COSTS

Many economic analysts believe the employment cost index is the best available measure of U.S. labor costs. For example, Abate referred to the ECI as "the best measure of compensation costs," and Griggs and Santow Incorporated described the ECI as "the best measure of wage behavior and benefits being paid, and ofthe pace at which such employment costs are rising." In many respects, these sentiments are probably correct, but other potentially useful measures of labor costs exist, including average hourly earnings and unit labor costs. This section describes the ECI and then considers whether this index is always better than the other labor cost measures.

An introduction to the ECI

The ECI is a quarterly measure of labor compensation per hour worked, including all wages, salaries, and benefit costs paid by employers. Wages and salaries are based on straight-time average hourly earnings, whether or not the employee is normally paid by the hour. Wages and salaries have historically accounted for a little over 70 percent of total employment costs. Nonwage benefits include paid leave, other supplemental payments, and employer contributions for insurance, retirement and savings plans, and legally required benefits. The methodology for compiling the ECI is described further in the accompanying box.

The inflation rate ofthe private-sector ECI has roughly paralleled the overall inflation rate, measured by the GDP price index, since 1980 (Chart 1).' The GDP price index is a broader measure of the general price level than the CPI, reflecting purchases by businesses and governmental units as well as consumers. The ECI increased by about 10 percent in 1981, when the country was experiencing high overall inflation rates. But the recession in the early 1980s produced substantial slack in labor and product markets, lowering ECI inflation to 3. …

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