The Employment Cost Index or ECI is a major US inflation survey. The quarterly index came packaged with a surprise: This quarter benefit costs rose by a very thin 0.1% as wages surged ahead by 1.1%. As a result total compensation was held to a gain of 0.8%, less than expected. But as surely as some are worried about that wage rise they are also curious about the small gain in benefits costs.

The story for benefits seems to be due to one particular technical issue related to pension contributions. Firms with defined benefit plans have fiduciary responsibility to keep their pensions funded according to some set rules. Since stocks were so strong, the BLS surmises that many firms simply took the run up in prices as their ‘contribution’ and did not inject new funds into the pension plans. This saving results in lower benefit costs to the firm but does not imply any reduction in benefits given to workers. In that sense it is bogus decline if we think in terms of labor costs. We have seen surging stock prices do this on other occasions in the past. On balance we can throw out the benefit number as a one anomaly.

The problems in this report remain as the rise in wages. And despite the hiatus in benefit costs this quarter we expect the Fed to take the wage component as an authentic a signal of tightening labor markets. The chart above shows quite clearly that the pressures are escalating rapidly and that they are strong in both goods ands services, but strongest in services where international competition plays the smallest role.

Services wages are rising at an extremely rapid pace. There are still being outpaced by the employment reports average hourly earnings measure (a poorer index) but that only serves to show there is another, albeit less pure wage measure that is showing the same effect. The Fed has been getting the same feed back in its regional Beige Book canvas. How long can the Fed ignore these signals? On balance I think this report will be sort of chilling from the Fed’s perspective.

The Fed will not be happy over the low growth print for Q1 2007. But there is no denying that wages are rising rapidly and that consumer incomes are growing solidly and the consumer spending is strong and price pressures are still in play. Despite the weak Q1 GDP print I think the Friday reports ( GDP, ECI and U of M final (revised)) put the Fed a half step closer to a rate hike ( yes, HIKE). It will take more information to do it but the Fed must be increasingly nervous about inflation and not so worried about growth after seeing the composition of GDP. Wage pressures, remember, tend to be sticky and longer lasting. These pressures are indeed getting out hand.

Moreover, although hours worked (in the monthly employment report) only rose at a 1.5% pace in Q1 2007 weak GDP will not allow that to become good news for productivity. With GDP advancing by 1.3% there is not much room for productivity growth and that will put the Fed even more on edge about wage pressures becoming cost pressures and leading to price hikes.