MNI INTERVIEW: Slide In US Unit Labor Costs Eases Inflation

Slow U.S. wage growth and ongoing productivity acceleration are driving a slide in unit labor costs and raise the risk that the Federal Reserve undershoots its inflation target over the medium term, former New York Fed economist Dominique Dwor-Frecaut told MNI, adding she sees the Fed resuming rate cuts by mid-year. 

The solid January jobs report Wednesday leaves the Fed comfortably on hold for a few more months, but labor market conditions have cooled and wage gains are at rates below those compatible with the Fed's 2% inflation target, Dwor-Frecaut said in an interview.    

"Wage growth is continuing to slow despite a bit of a tightening of the labor market," she said. "What we are seeing is a collapse in unit labor cost, which historically has been very tightly correlated with core PCE inflation. When we have a collapse in the unit labor cost, it suggest medium-term risk of undershooting inflation."  

So even as the January jobs report "lowers the risk of a Fed cut driven by labor market weakness, it doesn’t change the risk of cuts drive by disinflation." 

LESS INFLATION PRESSURE

Average hourly earnings in January rose 0.4% over the month and 3.7% over the year, down from 4.0% a year ago and 4.4% two years ago. The employment cost index, seen as the gold standard for measuring labor costs, showed compensation rising 0.7% in the final quarter of 2025, the slowest increase since 2021, and a 3.4% gain over the year, down from 3.6% in the previous quarter. 

With productivity growth hovering at 2.25% over the past three years, above its 1.5% recent historical average, unit labor costs are down to just 1.25% in the third quarter of 2025. 

"Both wages and inflation are determined together by the relative market power of workers and businesses, and workers don’t have much bargaining power. It’s surprising that the Trump administration's plan is they want Main Street to do better, yet the data are exactly the opposite," said Dwor-Frecaut, now chief U.S. economist at Macro Hive. (See: MNI INTERVIEW: Job Weakness To Keep Fed On Easing Path-Tilley) 

By year-end, core PCE inflation could fall to 2%-2.25%, she predicted, below the FOMC's median of 2.5%, as tariff effects wash out and the productivity boom allows the economy to run hotter without pushing prices higher. 

Fed Chair Jerome Powell said last month core PCE inflation would be just above 2% if not for tariffs and said he saw disinflation across services categories. 

PRODUCTIVITY LEAD

Recent productivity yields may be a lingering effect from the pandemic labor shortage, which forced businesses to be more efficient and make large investments in software, rather than more recent AI advances, she said. 

"The sectors taking the largest share of employment growth, such as health care and social services, are not typically associated with fast productivity growth, and suggests a slow process for AI integration," she said. 

Dwor-Frecaut maintains her view of three Fed cuts this year, more than market pricing for two.