[T]he compensation figures in the national accounts are subject to significant revision, as illustrated by the release of new data this week that suggests hourly compensation rose only 4-1/2 percent, not 7 percent, over the past year. Changes such as this make real-time estimates of unit labor costs and labor’s share of total income much less useful in our analyses than studies based on revised data might suggest. Finally, the existing wage data are not well suited for measuring certain concepts important to modeling and policymaking, such as marginal labor costs. For example, hourly compensation in the national accounts includes stock options at their exercise value rather than at their value at the time of issuance.

The robust job market is reinforced by the data on wages. September and October saw substantial increases in real average hourly earnings. Evidence of this wage trend has been reinforced in my conversations with many business leaders who indicate that hiring qualified people remains one of their primary challenges. Moreover, this tightness in the labor market exists for both skilled and unskilled workers.

We would like to see the economy slow some to relieve wage pressures... Frankly, the economy seems pretty strong outside of housing.  The job market remains healthy.  The risks with respect to growth are two-sided."

From Q&A session as reported by Reuters

Some of the divergence {between hourly compensation in the productivity estimates and the ECI} appears to be the result of an increased volume of stock option exercises in early 2006--an occurrence captured by the compensation per hour measure but not by the ECI--and these option exercises should not represent costs that firms actually internalize when calculating their marginal cost of production. Thus, in my own thinking, I have tended to discount, though not dismiss, the latest readings on labor costs. However, I acknowledge that rising labor costs are an upside risk to my inflation outlook, especially if they occur under product-market conditions in which firms can readily pass costs through.

In the past, deviations in the labor share of income from its mean value of roughly two-thirds have eventually been reversed.  But the two-thirds share is an empirical observation about the U.S. economy; it is not an immutable number derived from the first principles of economic theory...

A challenge for forecasters is deciphering whether this latest drop in the labor share is transitory, as such drops have been in the past, or whether some structural aspect of the economy, such as the wage-bargaining process, has changed to make the drop in the labor share permanent.  More likely, the adjustment process is taking a long time to play out, as it did in the 1990s, and some recent evidence may suggest that the gap is beginning to close.  Assuming that the drop is transitory, another challenge for forecasters is predicting whether the adjustment to real compensation per hour will be driven by a pickup in the growth of nominal compensation per hour or by a reduction in inflation.

That said, I must admit that I'm also less sanguine than I was a month ago about one particular factor in the inflation process—namely, labor compensation. This factor is a major component of business costs and can therefore affect the prices that firms charge for their products. A month ago it appeared that compensation was growing quite modestly. … However, recently revised information on compensation per hour suggests that wages and benefits are growing rapidly.  This blurs the picture considerably, since another measure, the Employment Cost Index, shows only moderate growth.

Here in Idaho, our contacts tell us that they have noticed shortages of skilled workers, and they also are seeing increasing difficulties recruiting unskilled workers, all of which has put strong upward pressure on wages in the state. While reports like these do heighten my sense of concern, I still draw some comfort from the fact that markups remain very high. So, even with more cost pressures, firms would have the room to absorb the increases without fully passing them on into their prices if competitive conditions in product markets induced them to do so.

The longer we go without signs of a deceleration in core inflation, the more we risk inflation becoming entrenched at this higher level. And if that happens, if people come to expect it to continue at two and three quarters, then it would take substantially more action on our part to bring it down to where we want to see it over time.

So that's the risk that I see, of inflation becoming entrenched at or above where it is now, and we're already seeing signs that that might be happening, because of the acceleration of compensation costs ...

Measures of labor compensation have given somewhat mixed signals about how tight labor markets have become. The rate of increase in the measure of compensation per hour derived from the national income and product accounts moved up appreciably over the four quarters ended in mid-2005 compared with the preceding year. This rise was apparently due in part to bonuses and stock options that may be only loosely related to labor market slack, however. Moreover, according to the employment cost index, which is based on a survey of firms, and to the growth in average hourly earnings in the payroll employment report, compensation pressures remained quite subdued. On balance, I do not believe conditions in labor markets have become excessively taut, but experience suggests remaining humble in making any such assessment.

Labor costs may increase for firms as the pool of available workers continues to shrink.  Thus far in the current economic expansion, firms have benefited from strong increases in productivity that have allowed them to offer higher wages to workers without affecting their profitability.  But as the labor market has tightened and as productivity growth has slowed, further efforts to expand may result in faster wage growth.

Unit labor costs so far have been of less concern than I might have expected a couple of years ago. Productivity gains have certainly helped.

In the latter half of last year, the growth of output per hour slowed, giving a boost to unit labor costs after two years of declines. Those increases were not large, however, and productivity growth seems to have increased at a good clip in the first quarter of this year.

As productivity growth returns to trend, unit labor costs will probably start to rise, potentially putting pressure on prices.

The overwhelming data suggests [inflation is] going to be driven, to a large extent, by unit labor costs.

Other potential inflationary pressures in the year ahead could come from past energy cost increases and higher prices of some imported goods. Labor costs are yet another variable. Although we still have a large supply of unemployed workers, I am now hearing more about shortages of skilled workers and that wages for some of those jobs are beginning to climb.