Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The Sticky Trap of Services Inflation
Transcript
- Lucas: If you look at the charts on the screen behind us right now, the S&P 500 is down nearly one percent over the last five days, and the ten-year Treasury yield has climbed back up to exactly five percent. The market is currently pricing in a Federal Reserve interest rate hike later this month, largely because headline inflation didn't budge much in August. But here is the thing that keeps me up at night: we are looking at the wrong part of the inflation equation. Luna: You mean the goods deflation that everyone talks about? Because groceries and electronics have actually gotten cheaper lately. Lucas: Exactly. Goods prices have fallen, which gives consumers some breathing room, but the Fed does not care about used cars or televisions when they set policy. They are staring at the Core PCE Price Index, which still rose from one hundred thirty point three four to one hundred thirty point seven in July. That is a quarter-point jump in a single month, and it is almost entirely driven by services, specifically shelter and healthcare. Luna: So even though real GDP growth has slowed to a crawl at one point five percent annualized, services prices are refusing to cool down? Lucas: That is the puzzle. Real economic activity is decelerating, yet the input costs for service providers are staying elevated. When we talk about sticky inflation, we usually think of wages, but the data shows something more structural. Let's look at the CPI numbers released this morning. The all cpi index moved from three hundred thirty-two point eight one to three hundred thirty-four point one. But if you strip out food and energy, core CPI went from three hundred thirty-six point seven nine to three hundred thirty-seven point eight. That half-point move is heavy. Luna: Half a point in a single month is significant. Is that mostly coming from rent and medical bills? Lucas: It is predominantly shelter. The lag effect in housing data is brutal. What tenants signed leases for eighteen months ago is still showing up in today's inflation metrics. And then there is healthcare, which is becoming a permanent fixture of these elevated prints. It is not a temporary spike; it is a baseline shift. The Fed knows this, which is why they are ignoring the nice drop in goods prices and keeping their eyes locked on those service sectors. Luna: But doesn't the slowing GDP suggest demand is fading? If people aren't buying as much, shouldn't service providers lower prices to attract business? Lucas: That is the standard theory, but the labor market complicates it. Nonfarm payrolls added roughly one hundred fifty-nine thousand jobs in August, and the unemployment rate held flat at four point one percent. Employers are still hiring, which means they still have wage pressure. If you are running a nursing home or an insurance firm, your biggest cost is people. Until labor costs come down significantly, those service prices cannot come down either. Luna: So we have a situation where the economy is slowing, but the cost structure remains rigid because of wages. That sounds like a recipe for stagflation fears. Lucas: Stagflation is a strong word, but we do have stagnation and inflation happening simultaneously. The JOLTS report showed job openings ticked up slightly to seven thousand two hundred seventy-one thousand, which contradicts the idea that the labor market is collapsing. Workers are still finding jobs, which means they still have income to spend on services, which keeps the prices high. It is a self-reinforcing loop. Luna: I wonder if the consumer outlook data from September reflects this anxiety. I saw headlines saying confidence plunged. Lucas: It does. Consumer sentiment is reacting to the cumulative effect of years of inflation, not just last month's print. When people see their grocery bill stabilize but their health insurance premium rise, they feel poorer. The breakeven inflation rate on the ten-year Treasury is sitting at two point three seven percent, which suggests markets expect inflation to stay above the Fed's two percent target for quite a while. Luna: Two point three seven percent is well above target. So the Fed is going to hike rates again to try and break that expectation? Lucas: That is the consensus view heading into the next FOMC meeting. Warsh is facing a tough battle, as the reports noted, because the data does not support a pause. If they don't hike, they risk anchoring inflation expectations higher. But if they do hike, they risk tipping that fragile one point five percent GDP growth into negative territory. It is a classic policy dilemma. Luna: It feels like they are walking a tightrope with no net below them. What about the dollar? Does a rate hike help stabilize the currency? Lucas: A rate hike generally supports the dollar, which helps import prices fall. But we are seeing the opposite pressure in some areas. The yen is weak, and global supply chains are adjusting. However, domestically, the main issue is that domestic service producers are not competing with imports. You cannot import a haircut or a hospital visit. So foreign exchange rates have less power to discipline those specific sectors. Luna: That makes sense. Domestic monopolies or local services are insulated from global competition. So the Fed really has only one tool left: squeezing demand until workers accept lower raises. Lucas: Precisely. Higher borrowing costs make mortgages more expensive, which cools the housing market, which eventually feeds into lower shelter inflation. But that transmission mechanism takes twelve to eighteen months. We are likely looking at a long period of restrictive policy before we see the full effect on those core services numbers. Luna: Do you think the market is underestimating how long that wait will be? The VIX hasn't spiked, so maybe investors are complacent. Lucas: Complacency is dangerous. Look at the Nasdaq, down one percent this week. Small caps in the Russell 2000 are down one point five percent. These are the companies most sensitive to interest rates. They are feeling the pinch now, which should tell us that the Fed's previous hikes are already working. The question is whether they need to add another increment to get the final mile of disinflation. Luna: I suspect they will do it. The data is too messy to declare victory. But let's take a quick breath here. If walking through the economy with us has made something click, or if you appreciate getting past the noise to understand what these numbers actually mean for your wallet, that is genuinely what keeps these episodes going. A couple of dollars a month is a huge help for independent journalism like this. You can support the show directly at buy me a coffee dot com slash fexingo. No ads, no algorithms, just straight conversation. Lucas: Thanks for the support. It allows us to dig into these deeper datasets without worrying about sponsor requirements. Back to the shelter issue—do you think there is any sector within services that might actually start cooling soon? Luna: Maybe transportation services? Like shipping or logistics? Those often lead the cycle in terms of price adjustments. Lucas: Logistics is a good candidate. Freight costs have normalized since the pandemic peaks. But transportation is a small slice compared to housing. Housing is about forty percent of the core basket. Until rents stop climbing, the Fed is stuck. And rents won't stop climbing until vacancy rates improve, which requires new construction, which requires cheap capital. Luna: So the Fed needs to cut rates to build houses, but they can't cut rates because inflation is too high. It's a paradox. Lucas: It is a genuine paradox. High rates suppress demand for homes, which lowers rents eventually, but it also kills new supply. The Fed is trying to solve a supply-side problem with a demand-side tool. That mismatch is why we are in this extended period of uncertainty. They are hoping demand destruction will win out, but the labor market is proving resilient. Luna: Resilient enough to keep pushing wages up, which then gets baked into services prices. It feels like we are trapped in a feedback loop. Lucas: We are. And the only way to break it is for the labor market to soften significantly. We need to see the unemployment rate tick up, perhaps toward four point five or five percent. Until then, wage growth will remain above levels consistent with two percent inflation. Luna: Four point five percent would be a big shock to the system. Do you think the Fed expects that to happen naturally with another hike? Lucas: They probably hope so. The Taylor Rule suggests rates should be higher given current inflation. By hiking, they are trying to engineer that labor market softening. It is a risky experiment because we haven't seen this exact combination of high growth and high inflation in decades. Most models assume a smoother recession, but we might be looking at a choppy, uneven decline. Luna: Choppy decline sounds exhausting for investors. How should listeners adjust their portfolios if this scenario plays out? Lucas: Defensive positioning. Companies with strong pricing power in services might still grow, but highly leveraged firms will suffer. Cash is king in this environment because yields are attractive. Don't chase yield in junk bonds; stick to Treasuries or high-grade corporates. The spread widening risk is too high if the Fed over-tightens. Luna: So quality over quantity. Avoid the leverage traps and wait for the dust to settle. Lucas: Exactly. Patience is the best strategy right now. The market is volatile, but the fundamental picture is clear: services inflation is the bottleneck, and it will take time to resolve. Watch the monthly CPI prints, especially the shelter component. That is your leading indicator for when the Fed might finally pause. Luna: One final thought: if shelter costs do start to drop next year, could we see a rapid relief rally in equities? Lucas: Absolutely. The market hates uncertainty more than bad news. Once the trajectory of core PCE turns decisively downward, multiple expansion could return quickly. For now, we stay cautious. Keep your powder dry and watch those service sector indices. Luna: Smart advice. Thanks for breaking down the sticky parts of the economy for us today. Lucas: Anytime. Next week, we'll look at how international trade flows are interacting with these domestic pressures. Stay tuned.