Thursday, September 07, 2006

Inflation Scare Beats Down Rally

This week saw the market decline seriously on Wednesday and some weakness moving forward. For those who didn’t see what happened there was a report out on Wednesday that gave the market an inflation scare.

Unit-labor costs, a key gauge of wages -- and inflation -- rose 4.9% in the second quarter, up from the previous estimate of a 4.2% gain, the Labor Department said. First-quarter labor costs were up 9%, sharply higher than the 2.5% rate last estimated. A jump in compensation costs was behind the advance, putting year-over-year labor costs for the quarter up 5% from a year ago -- the biggest annual increase since 1990.

And while nonfarm business-sector productivity rose 1.6% in the second quarter, up from previous estimates of 1.2%, it fell from the first quarter's 4.3% gain.

That’s a bad combination: decreasing productivity and increasing labor costs. Until now productivity has been climbing faster than labor costs, a crucial element in the formula to prevent inflation. Small-cap stocks, which have rallied recently on hopes the Federal Reserve won't raise rates any more, took a beating amid concerns policy makers may have to wade back into the fight if wages keep rising.

But the full picture is more complicated and not nearly so gloomy.

Economists noted that the second quarter's headline wage gains may have overstated the jump in labor costs, which likely reflected bonuses at financial companies that have enjoyed a strong run of profits recently. Nonfinancial wages, a labor-cost gauge favored by the Fed, rose at a more modest 2.6% pace in the second quarter, showing that while "the trend is still up in terms of unit labor costs, the degree of increase is significantly modified," said John Silvia, chief economist at Wachovia Securities.

Data showing continued weakness in the housing market -- and concerns that a slowdown in the key sector will ripple into the broader economy – will also play a big part in Fed plans and these concerns push toward holding rates steady.

To whatever degree the average worker sees some of these labor gains, they are not likely to continue for very long due to softening of the economy.

For now I would advise waiting on more data before setting off the inflation alarm, and I’m generally an inflation hawk!
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