Today's Employment Cost Index report expected to allow the FOMC to keep rates on hold tomorrow

Today we get the Q3 reading of the Fed’s preferred measure of wages growth – the Employment Cost Index (ECI). The consensus is for a reading of 1.0% to be delivered, in line with the Q2 reading and implying a year-on-year increase of 4.2%. If delivered this will be the slowest pace of growth since Q4 2021, but still represents wages growing faster than compatible with a 2% inflation target.

However, in 2021 upwards pressure on wages was still very much prevalent, whereas now the picture has reversed, suggesting that today’s reading may surprise to the downside. Further weight is added to this suggestion by the Atlanta Fed’s own wage tracker, which has a close correlation with the ECI, and is suggesting today’s reading could print as low as 0.5%. This is probably too low, particularly considering the 1.0% Q2 reading. But it does suggest that a reading of 0.9% today is not unrealistic to expect. Such an outcome would imply a year-on-year growth rate of 4.1%; but importantly the quarterly annualised rate would be just 3.6%.

Wages growth around this level would be welcomed by the Fed and may ultimately lead them to conclude that their job has been done in removing inflationary pressures stemming from the labour market. Assuming productivity growth of around 1-1.5% (productivity growth in 2022 was 1.6% - the latest figures are published this Thursday), wages growth of this magnitude would be broadly in line with a 2% inflation target. As such, the Fed will not want to see wages growth dropping too much lower as that would suggest an inflation rate below 2%.

Wages are the most significant cost factor in the services sector and as such play a key role in determining the level of core PCE, the Fed’s current preferred inflation gauge. Annual core PCE services rose by 3.67% in September, slightly slower than the rate suggested by the ECI numbers. This suggests that wages will need to continue to soften if this undershoot in the PCE reading is going to be sustained. But survey data suggests that this is indeed what will happen. The Quits rate in particular is a close leading indicator of the ECI index, with a lead time of approximately 6 months, and is currently pointing to an annual ECI rate of 3.5% by early Q2.

With the Fed placing so much weight on the ECI as a key metric of labour market strength, signs today that it is continuing to decelerate should allow the FOMC to keep interest rates on hold this week. Accordingly, based on our forecast of a sub-1% ECI reading today, we expect the FOMC to keep interest rates on hold tomorrow.