Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How Sticky Services Inflation Locks Fed Rates Higher
Transcript
- Lucas: The August CPI came in at 3.3 percent year-over-year, which sounds manageable until you strip away food and energy. The real problem isn't the headline number; it's that core services, excluding housing, have refused to budge. We are seeing persistent price increases in healthcare, legal fees, and personal insurance that suggest the inflation fight has moved into tougher terrain. Luna: Exactly. Everyone was watching the rent index like a hawk, but the services component is where the Fed actually loses sleep right now. It feels less cyclical and more structural. Lucas: Right. When I look at the breakdown, it's not just labor arbitrage anymore. It's about pricing power in sectors where competition is limited or regulated. Think about private health insurance premiums or even basic legal retainers. These aren't things consumers can easily switch providers for overnight. Luna: So if you're sick or need a lawyer, you pay what they ask. That lack of elasticity makes those prices incredibly sticky compared to, say, used cars or electronics. Lucas: Precisely. And here is the kicker: the ten-year breakeven inflation rate dropped slightly to 2.36 percent yesterday. Markets think long-term inflation is coming down, but the daily reality for consumers suggests otherwise. You can see it in the recent reports that inflation is outpacing wage growth again. Luna: That gap between wages and prices is dangerous because it erodes purchasing power without triggering a recession immediately. It just makes people feel poorer while keeping demand alive enough to support prices. Lucas: Which brings us to the Fed's dilemma. Jerome Powell and the committee know they cannot cut rates aggressively when services inflation is this resilient. If they ease too soon, those sticky service prices could reaccelerate before the housing component fully cools. Luna: But holding rates high also risks choking off the labor market. We saw the job openings drop in July. How much more pain can the employment side take before the Fed flips? Lucas: That is the exact tension playing out in the FOMC minutes. They are walking a narrow path. On one side, you have the risk of entrenched inflation driven by services. On the other, you have the risk of a sudden labor market deterioration. The effective federal funds rate is sitting at 3.63 percent, and most models suggest it needs to stay there until we see a clear break in services pricing. Luna: It feels like the Fed is waiting for a miracle in the insurance or healthcare data points. Those are the wildcards that could force their hand either way. Lucas: Or it forces them to do nothing, which is often the hardest decision of all. Let's pause for a second here. If walking through the economy with us has made something click, or if you appreciate hearing deep dives without interruption, consider supporting the show directly. We deliberately don't run ads on these episodes. If you want to support that choice, the link is buy me a coffee dot com slash fexingo. Luna: Yeah, your contributions help us keep the research rigorous and the audio clean. Thanks for being part of the network. Lucas: Back to the data. The Core PCE price index, which the Fed prefers, rose to 130.7 in July. While that is slower than earlier in the year, the monthly pace hasn't collapsed. It suggests that disinflation is happening, but it is glacial rather than rapid. Luna: Glacial is good news for stability, but bad news for anyone hoping for a quick rate cut next month. Patience seems to be the only strategy left. Lucas: Patience and precision. The market is pricing in a slight chance of a hike or at least no cuts, given the strength of the dollar and the yield curve. The two-year Treasury yield is reacting sharply to every whisper of sticky services inflation. Luna: And with the VIX hovering near elevated levels, volatility is likely to persist until the Fed gives a clearer signal. They won't give that signal until the services data breaks. Lucas: Let's talk about the composition of that services basket for a moment. It's not just medical care. It's financial services, education, and even repair services. These are areas where labor costs are embedded deeply. If wages stay rigid, these prices stay rigid. Luna: So unless we see a significant dip in hiring or a wage deflation event, which doesn't seem likely, the floor under services inflation remains quite high. Lucas: Exactly. And that floor is what keeps the Fed cautious. They don't want to declare victory prematurely. Remember how many times we heard 'peak inflation' in 2023? The Fed has been burned by premature easing before. Luna: True. Better to be wrong for too long than wrong for too short. The credibility cost of a second inflation wave is just too high for Powell to ignore. Lucas: Which means we are likely looking at a hold at the next meeting. The consensus is shifting away from a September cut toward a December hold or perhaps a very small step later in the year. Luna: A December hold would be a massive shift in sentiment. It implies the Fed sees more trouble ahead than the markets currently price in. Lucas: It does. And the bond market is starting to reflect that anxiety. The ten-year Treasury yield ticked up to 4.97 percent over the last five days. Investors are demanding more compensation for holding long-term debt because they fear the Fed might need to keep rates restrictive for longer than expected. Luna: That rise in yields hurts everyone from homeowners to startups trying to raise capital. It's a direct feedback loop from the services inflation problem. Lucas: Right. And it complicates the outlook for equities. The S&P 500 is down 0.8 percent over the last week, but the real pressure is on the smaller caps. The Russell 2000 dropped 2.4 percent. High rates disproportionately hurt companies that rely on floating-rate debt. Luna: Small businesses are already feeling the squeeze. If their borrowing costs go up while their own input prices remain sticky due to services inflation, margins get crushed from both sides. Lucas: That is a genuine risk. We are seeing a divergence between large corporations, which have locked in cheaper debt years ago, and the broader SME sector. The latter is vulnerable to this prolonged restrictive environment. Luna: So the Fed isn't just fighting inflation; they are managing a transition that could leave a lot of small businesses behind if they misjudge the timing. Lucas: Correct. And that political pressure mounts every time unemployment ticks up slightly. But the Fed's mandate is price stability first. They can only worry about maximum employment once they are sure inflation is tamed. Luna: Until then, they are going to look cold and unfeeling to the average worker who is still paying higher prices for services. Lucas: It is a brutal trade-off. The data for September will be crucial. If core services continue to climb or plateau, the door to any cut closes completely. Luna: And if it drops significantly, we might see a surprise pivot. But given the inertia in healthcare and legal fees, I wouldn't bet on a sudden drop. Lucas: I agree. The momentum is against a quick resolution. We are entering a phase of 'higher for longer' that feels permanent until proven otherwise. Luna: For listeners navigating this, it means budgeting for higher service costs and being cautious with leverage. The easy money era is definitely on pause. Lucas: Absolutely. Cash is king, but only if you are earning enough interest to offset the erosion. With rates around 3.6 percent, it's a modest buffer, but not a windfall. Luna: Thanks for breaking this down. It's a complex landscape, but understanding the services component makes the Fed's moves much clearer. Lucas: It does. As we head into next week, watch those services sub-indices closely. They will tell us more about the Fed's next move than any speech Powell gives.