MainStreet Macro: At your service

Data on the overall health of the economy delivered good news in June to round out the first half of the year. The economy created 209,000 jobs last month, according to the Bureau of Labor Statistics, and the ADP National Employment Report found that private employers added 497,000 new workers.

The U.S. labor market looks sure-footed so far in 2023, and the U.S. economy delivered 2 percent growth in the first quarter, up from an earlier estimate of 1.3 percent. Exports and consumer spending also have come in stronger than anticipated.

But, as we’ve said before, the job market is far from uniform. Worker shortages are affecting some industries more than others, and rising interest rates designed to chill inflation have inflicted pain in manufacturing and other rate-sensitive sectors.

In an earlier MainStreet Macro, we looked at how the goods sector contributes to – and is affected by – economic growth, inflation, and job creation.

This week, we turn our attention to the service sector, which so far has seemed more resilient to rising interest rates. Will the second half of the year bring a pivot for the service economy?

What is the service economy?

The service sector is so large and diverse that it’s best defined by what it’s not: Anything associated with the production of things you can touch is not a service.

That leaves a lot of room for a broad range of occupations, from health-care workers to waiters  and software developers to barbers.

Consumer-facing services were hit hard during the pandemic, but they’ve since become a key driver of the U.S. economic recovery, especially when it comes to job creation.

Four out of every 5 U.S. workers are employed in the service sector, and service providers created the bulk of new jobs in the first half of 2023 – more than 1.1 million – according to the Bureau of Labor Statistics.

Health care was the biggest driver of GDP growth in the most recent data. Four out of the 5 best-performing sectors were in services: Retail, real estate, hospitality, and information.

The service sector’s outsized performance has shown up in the labor market as well. Of the 497,000 in private sector jobs created in June according to ADP client data more than 75 percent were in services.

Not surprisingly, competition for workers is pushing up wages, but wage momentum is starting to ebb as the supply of workers increases.

Wages grew 6.4 percent in June from a year ago, according to ADP data, the slowest pace of increase since December 2021.

In leisure and hospitality, wages were up 7.9 percent in June. Growth in leisure and hospitality wages is outpacing all other industries, but it’s slowed considerably from the 14.8 percent growth recorded a year ago, in June 2022.

Goods inflation peaked that same month, even as service inflation was still gathering steam. Then supply chains recovered and energy prices fell. Good inflation slowed, but the tight job market sent labor costs soaring.

The wage-price spiral

In the first quarter of 2023, the cost of a unit of labor rose 3.8 percent year-over-year. That’s down from the peak in the second quarter of 2022, but higher than the growth in labor cost recorded before the pandemic. In the five years preceding the pandemic, the cost of labor rose by a year-over-year average of 2.1 percent.

Workers are a primary input for service providers. As labor costs rise, service providers come under pressure to raise prices. In aggregate, this dynamic can drive up inflation.

Economists call this feedback loop a wage-price spiral. As wage growth accelerates, prices go up, which leads workers to demand even higher wages.

We don’t seem to be at near-term risk of a wage-price spiral, but services inflation has ballooned over the past year and remains quite elevated.

U.S. inflation decelerated to 4 percent in May, but core service inflation – a measurement that omits the cost of energy services – was 6.6 percent.

This week’s Consumer Price Index will tell us whether we’ll get a long-awaited cooldown in service inflation this summer.

My Take

Before the pandemic, we had robust job gains and low and stable inflation. It was nice while it lasted, but there’s a new tradeoff in the economy now. Inflation, particularly when viewed through the lens of the service sector, remains the economy’s top concern.

Amid robust job gains, wage growth might keep inflation elevated and more volatile than in previous decades.

Two things need to happen if we want to tame inflation and sustain labor market health.

First, workers need to return to the service economy. This might be happening now, with labor-force participation moving toward pre-pandemic levels.

Second, those service workers need to be more productive. This will require more effort. Year over year, productivity levels have fallen for five straight quarters. Investing in human capital and technology to improve skill development could boost productivity in the long term. Given its dominance in the U.S. economy, a productive and growing service sector is the best defense against inflation.