This Week's State Of The Economy - What Is Ahead? - 09 December 2022

By: Taro Chellaram /Wells Fargo Economics & Financial Report/Dec 15, 2022

This Week's State Of The Economy - What Is Ahead? - 09 December 2022

The November release of the ISM services index kicked off the week with a surprisingly strong reading on the U.S. economy. The index rose 2.1 points to 56.5 despite consensus expectations for a roughly one-point decline. The outturn was higher than any of the 60 forecast estimates submitted to Bloomberg. The better-than-expected gain was due almost entirely to a 9.0-point increase in the business activity index. This component is now at its highest reading in almost a year, signaling economic growth in the service sector remained widespread through November. The new orders component fell slightly but remained in solid territory at 56.0.

While the slowdown in service sector activity has been more muted than manufacturing, so has the impact on prices. The ISM services prices paid component declined last month, but a reading of 70.0 suggests price pressures still remain elevated. In contrast, the prices paid component in the ISM manufacturing index has fallen to 43.0, the lowest reading since May 2020. This is the largest gap on record for the two price indices and speaks to the different inflation dynamics for service-providers and manufacturers.

This week's producer price index (PPI) data for November was reflective of this divergence between goods and services inflation. The PPI for final demand increased by 0.3% in November. Beneath the headline, prices for final demand services rose 0.4%, while final demand goods prices inched up just 0.1% in the month. Even as we see a reprieve in goods prices, the slow descent in the larger services sector speaks to the fact that it will take time for inflation to return to target and that the Fed still has work to do in its fight against inflation.

Fortunately for the Fed's inflation fight, there was other data this week that suggested some modest improvement in reducing labor cost growth. Revisions to the unit labor cost and productivity figures for the third quarter showed unit labor costs rising at a 2.4% annualized rate in Q3, the slowest pace of growth since Q1-2021. Unit labor costs adjust hourly compensation for labor productivity. Put another way, unit labor costs measure how much it costs a business to produce one unit of output. All else equal, faster unit labor cost growth should be inflationary, and slower growth should be disinflationary. Although the Q3 reading was encouraging, this data can be very volatile on a quarter-to-quarter basis, and over the past year unit labor costs are up 5.3%, roughly triple the average pace in 2019.

Slower labor cost growth could be in the offing if the labor market cools in the year ahead, and this week's unemployment claims data suggest some looser labor market conditions on the margin. Continuing jobless claims increased to 1.67M through the week ending November 26. The above chart shows how continuing claims have been on the rise since bottoming at the beginning of the summer. On an absolute basis, the level of claims is still quite low. For context, continuing claims averaged 1.70M in 2019 in what was a tight labor market. But as we look to 2023, we expect this trend to continue as the labor market rolls over and employment begins to outright contract by the second half of next year. This in turn should help reduce labor cost growth and, by extension, move inflation much closer to the Federal Reserve's 2% target.

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