Latest / Stagflation Conversations with Fexingo: High Inflation, Slow Growth, and 1970s Echoes / Why Core Services Inflation Is The Real Stagflation Trap
Transcript
- Lucas: Look at the headline CPI number for August, sitting at three hundred thirty-four point one, and you might think the worst of the post-pandemic price shock is finally over. But if you peel back the layers to look at core CPI, which strips out food and energy, it climbed slightly to three hundred thirty-seven point eight. That small uptick tells a much more uncomfortable story about where the economy is actually heading. Luna: Right, because the volatile stuff like gasoline and eggs has stabilized, but the things we actually rely on daily—housing, healthcare, insurance—are refusing to come down. It feels less like a cooling trend and more like a permanent shift in baseline costs. Lucas: Exactly. And when you pair that persistent services inflation with real GDP growth dropping to just one point five percent annualized, you get the textbook definition of stagflation. We aren't seeing the robust expansion that usually accompanies low unemployment, nor are we seeing the sharp deflation that signals a healthy recession. We are stuck in this weird middle zone where prices keep rising while economic momentum stalls. Luna: The labor market data supports that stagnation too. Job openings ticked up slightly to seven thousand two hundred seventy-one thousand, but the unemployment rate hasn't budged from four point one percent. It is not a tightening labor market, but it is certainly not loosening either. Lucas: That is the key friction point. In the seventies, wages lagged behind inflation so badly that workers lost purchasing power rapidly. Today, average hourly earnings are up to thirty-seven dollars and eighty cents, which sounds good until you realize that inflation is still outpacing that growth. Consumers are effectively getting poorer every month despite having a job, which dampens spending on discretionary items. Luna: So the Fed is trapped. If they cut rates to help the slowing growth, they risk letting that services inflation run wild again. If they hold or hike, they risk choking off the fragile job market. Lucas: Precisely. And this brings us to the specific mechanics of why services inflation is so stubborn compared to goods. Goods were supply-constrained during the pandemic, so once supply chains fixed themselves, prices collapsed. Services are labor-intensive. You cannot automate a nurse, a lawyer, or a plumber overnight. As long as wages need to rise to attract workers, service prices must rise to cover those payroll costs. Luna: Which means the only way to truly break that cycle is through a significant reduction in demand, which usually means a recession. But the current data suggests we are trying to avoid that at all costs. Lucas: Before we dig deeper into the shelter cost anomaly, I want to mention something important. A handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that is literally what funds making this many of these episodes possible. We do not run ads, and that direct support keeps the research rigorous and the analysis independent. It makes a huge difference. Luna: Yeah, it really does. Knowing that the people listening here value this kind of deep dive allows us to spend time on the nuanced data points instead of chasing viral headlines. Lucas: Thanks for supporting the show. Now, let's get back to the shelter issue, because it is the single largest driver of that core CPI number. Shelter costs make up roughly a third of the index, and they are calculated using lagging data like rent listings and owner equivalent rent. Luna: So even if home prices have cooled or rental vacancy rates have improved in major cities, the official statistics won't reflect that for another twelve to eighteen months. We are essentially driving the car by looking in the rearview mirror. Lucas: That lag is dangerous because it gives the Federal Reserve a false sense of security. They might see core inflation falling on paper and decide to pivot early, not realizing that the underlying service costs are still accelerating in real-time. The latest consumer sentiment survey plunged in September specifically because people feel the pinch now, not because of what the lagging data says. Luna: It is interesting that the VIX remains elevated despite the market being near all-time highs. Investors are hedging against this exact scenario—a sudden realization that inflation is stickier than expected. Lucas: Right. The S&P five hundred is up, but the Russell two thousand, which tracks smaller domestic companies, is down significantly. Small businesses are feeling the brunt of those higher service costs because they don't have the pricing power that large tech or consumer staples giants possess. Luna: So the divergence between mega-cap profits and small-business margins is widening. That is a classic sign of an economy where scale matters more than efficiency. Lucas: And it ties back to the wage dynamics. Large corporations can absorb higher wages by squeezing suppliers or leveraging technology. Small businesses just raise prices, which feeds directly into that services inflation loop. It is a self-reinforcing cycle that is very hard to break without external intervention. Luna: Does AI play a role here? Or is it too early to see productivity gains offsetting those labor costs? Lucas: That is the great question. On paper, AI should lower costs. But in practice, implementation is expensive and slow. Most firms are spending heavily on infrastructure before they see any reduction in headcount or hours worked. So right now, AI is adding to capital expenditure rather than subtracting from operational costs. Luna: So it is acting like a tax on efficiency in the short term, rather than a relief valve. We will likely see the benefits only after the initial adoption curve flattens out. Lucas: Exactly. And until then, the cost structure of the services sector remains rigid. Look at healthcare. It is one of the few areas where demand is inelastic. People need care regardless of the economy, and providers have immense pricing power. That sector alone is enough to keep core inflation from hitting two percent. Luna: It feels like the structural changes in the labor force—the aging population, the skills mismatch—are permanently raising the floor for service prices. We are not going back to the cheap services era of the nineties. Lucas: I agree. The demographic tailwinds that used to suppress labor costs are now headwinds. Fewer young workers relative to retirees means upward pressure on wages across the board, particularly in care services and professional support. That is baked into the long-term trajectory. Luna: So investors should adjust their expectations for the 'neutral rate' of interest. If inflation stays around two and a half percent, the neutral rate might need to be higher than the historical average of two percent. Lucas: Spot on. The old models assumed mean reversion would pull everything back to zero inflation and two percent growth. That assumption is no longer valid. We are living in a new regime where moderate inflation is the baseline, not the exception. Luna: How does that change portfolio allocation? Bonds are struggling because yields are stuck, and equities are bifurcated. Lucas: It favors assets with strong cash flows and pricing power. Companies that can pass on inflation to consumers without losing volume are the winners. Those are mostly the monopolistic or semi-monopolistic platforms we mentioned earlier. Defensive sectors like utilities and telecom also benefit because their regulated returns often include inflation adjustments. Luna: What about real assets? Gold is hovering near four thousand four hundred dollars an ounce. Is it just a hedge against monetary failure, or is there a structural demand driver? Lucas: It is both. Central banks are buying gold at record paces to diversify away from the dollar, and retail investors are using it as insurance against currency debasement. When real rates are low or negative, gold becomes very attractive. It is not speculation; it is a rational response to uncertain monetary policy. Luna: So the narrative isn't that gold is a bubble, but that it is a necessary component of a diversified portfolio in a stagflationary environment. Lucas: Absolutely. And it highlights the erosion of faith in fiat currencies as the sole store of value. When governments are forced to choose between fighting inflation and stimulating growth, they often pick growth, which devalues the currency over time. Luna: That political reality seems inevitable. No administration wants to trigger a deep recession to kill inflation, especially with an election cycle approaching. Lucas: Right. The political pressure to keep the economy growing overrides the technical need to cool it down. This creates a fiscal dominance scenario where monetary policy is subservient to political goals. That is historically the most inflationary setup of all. Luna: So we are watching a game of chicken between the Fed and the Treasury. One of them has to blink first. Lucas: Or neither blinks, and we get a period of sustained, moderate inflation that erodes savings quietly rather than exploding violently. That might be the most likely outcome given the current data. Luna: A slow bleed rather than a heart attack. It is a harder scenario to trade because there is no clear crisis point to exploit. Lucas: Exactly. It requires patience and a focus on quality assets that can withstand the grind. Volatility traders will struggle in this environment because the moves are gradual and directional. Luna: For listeners managing their own portfolios, what is the takeaway? Avoid leverage, hold high-quality equity, and maybe allocate a portion to gold or commodities? Lucas: Yes, but keep cash reserves high too. Liquidity is king when the rules are changing. If a genuine recession hits, having dry powder allows you to buy assets at discounted prices. Over-leveraging in a stagnant economy is the fastest way to get wiped out. Luna: It is a defensive posture. Wait for clarity before committing to aggressive growth bets. Lucas: Precisely. The data for September will be crucial. If inflation ticks up further, the Fed will signal a hawkish pause, which could hurt equities but strengthen the dollar. If it cools, we might see a rally, but only if the growth data supports it. Luna: We will have to watch the breakeven rates closely. They are currently at two point three six percent, suggesting markets still believe the Fed can manage this. Lucas: Belief is a powerful thing in finance. But belief is not a strategy. The strategy is to prepare for the possibility that the Fed is wrong, and inflation stays higher for longer. Luna: A sobering thought, but a necessary one. Thanks for walking us through the mechanics of this trap, Lucas. Lucas: Anytime, Luna. Let's see if the next quarter confirms this thesis or breaks it entirely.