After spending much of September and October looking at all the monthly releases of important economic data, you may have thought you knew all there is to know about the American economy, how it works, and how you can draw conclusions from economic reports that will help you as an investor. From the release of August data on the producer price index to the September report on the consumer price index, you looked at over a dozen different reports on various parts of the economy.
However, along with all of these monthly data releases, there are other important measures that are only available on a quarterly basis. The first article in this series dealt with one such report, which provided data on the U.S. current account. Another report that only comes out four times a year is the Bureau of Labor Statistics' employment cost index. This article explains how the BLS calculates the ECI, and looks at how economists and other analysts use the report to draw conclusions about the overall state of the economy.
The basic concept
The employment cost index provides a measure of what employers pay their workers. Movements in the index indicate whether overall labor costs are rising or falling. In order to calculate the index, the BLS sends field economists to visit employers across the country. These field economists collect information on several topics, including the nature of the employer's business, how many employees the business has, the duties and responsibilities of the various jobs, how much employees are paid, what benefits are available to employees, and how many hours employees work. In its most recent report, the BLS performed nearly 50,000 observations at more than 11,000 different employers to gather enough data to provide a statistically valid sample.
Once it gathers raw data, the BLS then performs two types of analysis. For wage and salary costs, payments for ordinary earnings are used; this includes periodic additional compensation such as production bonuses and incentive payments. However, supplemental wages for overtime, weekend and holiday pay, and shift differentials are excluded from wage and salary costs and instead are considered benefits. For the cost of benefits, the BLS considers supplemental wages, paid leave, insurance benefits, retirement plans, and legally required benefits such as Social Security, Medicare, and unemployment insurance.
After performing this analysis, the BLS applies seasonal adjustments to the resulting figures and then calculates index numbers based on a comparison with figures from a certain baseline quarter. The BLS just recently set December 2005 as its new base quarter; as a result, figures from December 2005 are assigned an index value of 100, and subsequent index figures are measured against that period. In addition to overall figures for all civilian workers, the data are broken down between wages and benefits, blue-collar and white-collar workers, and among a number of different industries.
The employment cost index is used in a variety of ways by government and private industry. The federal government uses the ECI to make automatic changes to compensation for white-collar government workers and to adjust the amount paid for labor costs under government contracts. Furthermore, adjustments to Medicare reimbursement rates to hospitals and other health-care providers are based in part on changes in the ECI. Within the private sector, many companies refer to the ECI in long-term contracts that involve a significant amount of labor. This ensures that if labor costs rise substantially, the contract price will rise accordingly to ensure parity between the parties to the contract. Businesses that have collective bargaining agreements with their workers sometimes use the ECI to determine periodic pay raises.
In addition to its use in determining appropriate cost adjustments, the ECI is also viewed by economists as a critical measure of potential inflation. The Federal Reserve closely watches the ECI for signs of accelerating cost increases in the labor market, which may lead to general price inflation throughout the economy. Many economists fear that when labor costs rise, businesses have only two choices: they can either pass on their higher costs to consumers by raising prices, or they can absorb the higher costs themselves and reduce their profit margins. Neither of these options is particularly attractive to businesses, and both can have harmful impacts on stock prices.
This week's release showed overall costs increased 1% in the third quarter, with costs of benefits outpacing wage increases. Private-sector costs increased at a slower rate than those of government employers. Some of the slowest increases were seen in the manufacturing sector, while health-care providers saw above-average cost increases.
It is curious that the Fed pays particular attention to the quarterly release of the ECI, especially since similar data on changes in hourly earnings are included in the Labor Department's monthly employment report. The primary reason can be seen in a particular adjustment that the ECI makes. Unlike the hourly earnings data, the ECI adjusts its figures to negate the effect of workers who change jobs from one occupation to another. For instance, if more high-paying jobs are available in one quarter than another, then average hourly wages will be higher even though each employer's wage costs will have stayed constant. Because the ECI is more resistant to these temporary changes, the Fed can use the ECI as an indicator of the particular type of labor costs about which it is most concerned in determining monetary policy.
One criticism of the ECI is that it does not include the value of stock options given as compensation to employees. This represents a significant omission, especially for companies like Cisco
In summary, the quarterly BLS release of the employment cost index provides a look at what employers have to pay in order to obtain the labor they need. By observing changes in the index, you can potentially anticipate economic trends that may affect the companies in which you invest.
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Intel is a Motley Fool Inside Value selection.
Fool contributor Dan Caplinger keeps his employment costs down the easy way: He doesn't have any employees. Dan doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy doesn't cost you a dime.