Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Services Sector for Inflation Clues
Transcript
- Lucas: So the June CPI came in at 3.5 percent year-over-year, down from 3.8 percent in May. That's the third straight decline. The market took it as a sign the Fed might be able to cut rates soon. But I think that reading is too simple. Luna: Because the Fed doesn't just look at the headline number. They've been pretty vocal that services inflation is the real sticking point. Lucas: Exactly. Specifically, core services excluding housing — what the Fed calls 'supercore' — is still running at about 4.2 percent. That's barely budged in months. And that's the piece that's most tied to domestic labor costs and pricing power. Luna: And if today's episode is making something click about how the Fed actually reads inflation, that's exactly the kind of value that keeps this show going. We keep Fexingo ad-free because listeners who find it useful chip in at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small thing that makes a big difference. So back to supercore — why is it so sticky right now? Luna: Well, look at the components. Healthcare, auto repair, hospitality — these are labor-intensive industries where wages are still climbing. The Atlanta Fed's Wage Growth Tracker for June shows median wage growth at 4.9 percent, which is still too high for the Fed's comfort. Lucas: Right. And there's a new Fed research paper from the San Francisco branch that surveys firms about their pricing intentions. It found that nearly 40 percent of services firms plan to raise prices in the next three months, compared to about 25 percent for goods producers. That's a huge gap. Luna: So goods inflation is cooling — we saw that with the wholesale prices dropping 0.3 percent in June, driven by a big decline in gasoline. But services firms still feel they have pricing power. Lucas: Part of it is that consumers are still spending on experiences. The Fed's Beige Book, which came out this week, specifically called out that the World Cup gave bars and restaurants a needed boost. But it also said consumers are showing warning signs — they're trading down, using credit more. That tension is exactly what the Fed is watching. Luna: So if services inflation stays sticky, the Fed can't cut rates even if headline CPI looks good. That's the supercore story. Lucas: Right. And the market is pricing in about two rate cuts by year-end. But Fed Governor Christopher Waller said in a speech last week that he needs to see 'several months' of improvement in services inflation before he'd support a cut. So the bar is high. Luna: What would it take for supercore to come down? Slower wage growth, obviously. But also maybe a pullback in consumer demand for services. Lucas: Exactly. The Beige Book mentioned that some contacts are seeing softer demand for dining out and travel. If that continues, services firms might lose their pricing power. But it's not there yet. Luna: And there's a structural story too. Healthcare employment is still growing at about 50,000 jobs per month. That's a lot of new demand for services that doesn't easily go away. Lucas: That's a good point. So the Fed is really in a wait and see mode. They need to see the data confirm that the services sector is cooling before they move. The next big data point is the July jobs report, which will give us the wage growth number. Luna: And the July CPI, which comes out in mid-August. If supercore stays above 4 percent, I think the Fed holds steady at the September meeting. Lucas: I agree. The market is probably too optimistic. The futures curve shows a 70 percent chance of a cut in September, but if supercore doesn't budge, that could flip quickly. Luna: So to sum up: headline inflation is falling, but the Fed is focused on the sticky part — services. And until that softens, don't expect rate cuts. Lucas: That's exactly it. And the 10-year breakeven inflation rate, which fell to 2.23 percent, suggests the bond market also expects inflation to moderate. But breakevens are noisy. The real signal is in the services data. Luna: Well said. Next week we'll look at the FOMC's July meeting — they won't change rates, but the statement language could shift. We'll parse it for you. Lucas: Until then, keep an eye on those service-sector jobs numbers. And if you found this breakdown useful, you know where to find us.