Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / What Sticky Services Inflation Means for the Fed
Transcript
- Lucas: So the headline CPI came in at 334.0 for May — up from 332.41 in April. That's about a two-tenths of a percent monthly gain, which on its own looks pretty benign. But when you peel back the layers, the Fed's real headache is hiding in the services numbers. Luna: Right, because goods inflation has actually been cooling. The issue is that services — things like rent, insurance, medical care — are staying sticky. Lucas: Exactly. Core CPI excluding food and energy hit 336.1, up from 335.42. The month-over-month change was about 0.2 percent, but the composition matters a lot. Shelter costs rose 0.4 percent month over month. Car insurance jumped 0.7 percent. Airline fares actually dropped, which helped, but the broad services category is still running well above the Fed's comfort zone. Luna: And this is what Fed Chair Warsh has been calling 'supercore' — services excluding shelter and energy. That's the metric they watch most closely now, right? Lucas: That's right. Supercore services inflation has been hovering around 3 percent annualized, versus the pre-pandemic average closer to 2 percent. The Fed wants to see that number come down before they feel confident cutting further. Right now the effective fed funds rate is 3.63 percent, and markets are pricing in maybe one more cut this year, but that's contingent on services inflation cooperating. Luna: The ten-year breakeven rate dropped to 2.21 percent from 2.23. That suggests bond traders expect long-run inflation to stay near the Fed's target. But the near-term path is what's uncertain. Lucas: Yeah, the breakeven is a market-based measure of expected inflation over the next decade. At 2.21, it's almost exactly at the Fed's 2 percent target if you account for some risk premium. So bond markets are saying 'we trust the Fed to get this under control over time.' But the month to month numbers are what matter for policy decisions. Luna: And there's a new wildcard: the Iran oil sanctions waivers that came out this week. Analysts are saying that could ease energy costs, which would help headline inflation, but maybe not services. Lucas: Right, the headline from CNBC: 'U.S. issues sweeping Iran oil sanctions waivers, unlocking billions in revenue for Tehran.' If that leads to more oil on the global market, gasoline prices could drop. That feeds into headline CPI directly — energy is about 7 percent of the CPI basket. But it doesn't do much for services like rent or medical care. In fact, lower energy costs might actually boost consumer spending, which could keep services demand elevated. Luna: So it's a double-edged sword. Lower gas prices help consumers, but they could delay the cooling in services inflation that the Fed needs. Lucas: Exactly. And that's the dilemma. The Fed has already cut rates from 5.5 percent down to 3.63 percent over the past year. The labor market is still reasonably strong — factory job cuts got a lot of attention, but overall payrolls are still growing. If services inflation doesn't moderate, the Fed might have to pause rate cuts, or even hint at a hold, despite the progress on goods and energy. Luna: Let me ask you this: is there any evidence that services inflation is actually starting to respond to the rate cuts? Or is it just structural at this point? Lucas: There are glimmers. Rent of shelter is starting to slow — it's still high, but the year-over-year rate has come down from 6.2 percent a year ago to around 5 percent now. That lag is because rent changes take 12 to 18 months to show up in CPI. So the Fed is banking on that continuing. But categories like car insurance and hospital services are still running hot, and those are less responsive to interest rates. A lot of that is state-level regulation and supply constraints — not monetary policy. Luna: So you're saying the Fed might have to accept that some services inflation is just going to be higher than 2 percent, and they'll have to aim for a higher overall inflation target? Lucas: That's the quiet debate inside the FOMC. Publicly, they still say 2 percent. But privately, some members are starting to ask whether supercore should be 2.5 or 3 percent given structural changes in the economy — an aging population, more healthcare spending, tighter insurance markets. Warsh hasn't endorsed that view, but he hasn't ruled it out either. Luna: Interesting. So the next CPI release on July 16th is going to be a big one. If services inflation stays elevated, we could see market expectations for rate cuts get pushed back. Lucas: If today was actually useful to you, the way these stay ad-free is listener support — buy me a coffee dot com slash fexingo. That goes directly to keeping the economics coverage independent and focused on the data, not the hype. Luna: Yeah, it really helps. A small gesture adds up, and it means we keep digging into these numbers without any sponsor pressure. Lucas: Back to the data — one other thing I'm watching is the PCE price index, which is the Fed's preferred measure. The April reading came in at 130.9, up from 130.38. Core PCE was 129.6, up from 129.32. That's about a 0.2 percent monthly gain, which is right around the Fed's target if annualized. But again, the services components are the sticking point. The May PCE report comes out next week, and that will give us a clearer picture. Luna: And that report will include the May data, so we'll see if the services stickiness continued into May. The CPI we just talked about was May, so the PCE should be consistent. Lucas: Right. One thing to note is that PCE weights services more heavily than CPI — about two-thirds of the basket. So if services are sticky, that's even more consequential for the Fed's target. The last reading of core PCE was 2.7 percent year over year in April. The Fed wants 2 percent. That gap is the services gap. Luna: And if we get a surprise to the upside on services, that could rattle markets. The S&P is already down 0.9 percent over the past week, and the Nasdaq is down 2.1 percent. A hot PCE could trigger another sell-off. Lucas: Exactly. The market is pricing in a soft landing — rate cuts without a recession. But if the Fed has to pause because services inflation won't cooperate, that soft landing narrative gets challenged. The Russell 2000 is up 2.2 percent over five days, which suggests small caps are still optimistic about rate cuts, but that optimism might be fragile. Luna: So the bottom line: the Fed's next move depends almost entirely on what happens with services prices. Goods and energy are cooperating, but services are the stubborn patient that won't heal. Lucas: That's a good way to put it. And we'll be watching every data point between now and the July FOMC meeting. Thanks for sticking with us.