Latest / Stagflation Conversations with Fexingo: High Inflation, Slow Growth, and 1970s Echoes / The Services Trap Fueling Modern Stagflation
Transcript
- Lucas: If you look at the headline CPI number for September, it’s three hundred thirty-six point three, which sounds manageable. But if you peel back the layers to look specifically at the services sector, excluding food and energy, the story changes completely. Luna: Right, because goods deflation has been doing most of the heavy lifting lately, masking what’s actually happening in the service economy where wages are still climbing. Lucas: Exactly. The core PCE price index just ticked up to one hundred thirty point five, and when you look at the underlying drivers, it’s not commodities or supply chain bottlenecks anymore. It is pure labor cost push. We are seeing average hourly earnings in the private sector rise to thirty-seven dollars and eighty cents, but real GDP growth has already slowed to two point two percent annualized. Luna: So we have a classic divergence: prices going up because wages are up, but output isn’t growing fast enough to justify those higher costs, which is basically the textbook definition of stagflationary pressure. Lucas: That is exactly the trap. And this brings us to something I want to talk about today, which is why the services sector is becoming the new battleground for inflation. Unlike manufacturing, where you can automate or offshore production, services are intensely local and labor-intensive. Luna: And with job openings down to seven thousand seventy-nine thousand, you would think the labor market is cooling enough to stop wage spirals, but the data suggests otherwise. Lucas: It is cooling, but only slightly. The unemployment rate is sitting at four point two percent, which is still historically low. When you combine that with a budget deficit swelling to almost two trillion dollars, you have a government that is effectively subsidizing demand while the private sector faces rising input costs. Luna: It feels like the Fed is trying to hit a moving target here, especially with Kevin Warsh suggesting they might surprise the market, but the structural issue seems to be deeper than just interest rates. Lucas: Before we dig into the specific mechanics of how services are driving this, I want to take a quick moment to acknowledge the people who keep this show running. If walking through the economy with us has made something click, or if you just appreciate the deep dive into these complex numbers, listener support is what allows us to produce this ad-free content every single day. Luna: Yeah, it really does make a difference. You can find us at buy me a coffee dot com slash fexingo — that's F. E. X. I. N. G. O. Lucas: Thank you. Now, back to the data. The reason I am focused on services is that they account for roughly seventy percent of the consumer basket, yet they are the least efficient part of the economy to manage during an inflationary cycle. Luna: Because you cannot easily increase the productivity of a nurse or a teacher without compromising quality, so their wages tend to rise faster than the value they produce in purely economic terms. Lucas: Precisely. Look at the recent headlines about women potentially being at greater risk from AI job losses. That narrative misses the point. The real risk isn't just displacement; it's that the remaining human-centric roles in healthcare and care services are becoming exponentially more expensive. Luna: So the AI boom is actually exacerbating the services inflation by drawing talent away from other sectors, leaving even fewer workers to handle the essential services that don't scale well. Lucas: That is a very sharp observation. When you pull talent out of traditional roles to work on AI infrastructure, the supply of labor for things like home health aides or specialized education shrinks further. This drives up wages in those sectors, which then gets passed directly to the consumer. Luna: And since these are non-tradable goods, you can't just import cheaper alternatives from abroad like you can with electronics or clothing. The price stays high domestically. Lucas: Correct. This is why the ten-year breakeven inflation rate is stuck at two point three five percent. Markets know that the Fed cannot simply raise rates high enough to crush services inflation without causing a severe recession in the housing and construction sectors. Luna: Which brings us back to the nominal GDP figure of thirty-two point five trillion dollars. The gap between nominal and real growth is widening, which means a significant portion of that economic activity is just inflation eating up the gains. Lucas: Yes. Real GDP grew by two point two percent, but nominal growth was much higher. That spread represents the inflation tax on the economy. For businesses, this means margins are getting squeezed because they have to pay higher wages but cannot always raise prices without losing customers. Luna: It creates this weird paralysis where companies hoard cash instead of investing, which slows down innovation and keeps productivity growth flat, which in turn keeps wages high relative to output. Lucas: That is the vicious cycle. And with initial jobless claims ticking up to one hundred ninety-nine thousand, we are starting to see some softening in the labor market, but it is too late to prevent the current wave of services inflation from embedding itself into expectations. Luna: So the question for investors right now is whether the S&P 500 can maintain its level of seven thousand six hundred ninety-one when the underlying earnings quality is being degraded by these rising service costs. Lucas: It is a valid concern. The Dow is holding up better at fifty-one thousand nine hundred sixty-six, partly because it is weighted toward older, more stable industrial firms that have already absorbed many of these labor cost increases over the last few years. Luna: Whereas the tech-heavy Nasdaq, down two point eight percent recently, is more exposed to the future cost of AI implementation and the operational overhead of maintaining these massive data centers. Lucas: Right. And gold is up one point one percent to four thousand one hundred fifty-four dollars, which is the market's way of hedging against the uncertainty of whether the Fed will finally break something important or just watch inflation simmer in the services sector. Luna: It feels like we are in a period of economic inertia. Growth is too slow to be exciting, but inflation is too sticky to be ignored, leaving policymakers with very few good options. Lucas: That is the reality. The fiscal drag is real, with the deficit hitting two trillion, and the monetary tools are blunt instruments that primarily affect borrowing costs, not the structural wage pressures in healthcare and education. Luna: So for listeners managing their own portfolios, the lesson might be to focus on companies with pricing power in essential services, rather than hoping for a broad-based disinflation that makes everything cheaper. Lucas: Exactly. You want businesses that can pass on these wage increases to consumers without losing volume. That is rare in this environment, which is why cash positions are looking attractive again. Luna: It is a reminder that the old rules of diversification might need updating when the primary driver of returns is no longer growth, but resilience against cost-push shocks. Lucas: Well said. As we head into the next quarter, keep your eye on the core PCE data and the job openings report. If those job openings continue to fall below seven million, we might finally see the wage pressure ease, but until then, the services trap remains the dominant force in the economy. Luna: I think that is a prudent place to leave it. We will see if the Fed decides to wait out the rest of the October meeting or if they feel compelled to signal a change in strategy sooner. Lucas: Agreed. Thanks for tuning in to Stagflation Conversations. Let us know which of these services sectors you think will be the hardest hit in the coming year.