Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / What the Fed Makes of Sticky Core Services Inflation
Transcript
- Lucas: So the equity market has had a rough five days — the Nasdaq is down over five percent, the S&P 500 off nearly three. But if you're watching what the Fed is watching, the action isn't in stocks. It's in something much more granular: core services inflation excluding housing. Luna: Right — the so-called 'supercore.' The thing Powell keeps pointing to as the most domestically driven part of inflation. Lucas: Exactly. And it's the part that has been stickiest. The April CPI report, which came out a few weeks ago, showed core CPI — that's ex food and energy — rising to 335.4, up from 334.17 in March. That's a year-over-year increase of about 3.6 percent, still well above the Fed's two percent target. Luna: But headline CPI has been coming down, right? Energy prices have moderated a bit from the Iran-related spike earlier this year. Lucas: They have. The headline number is less alarming. But the Fed's preferred gauge is the PCE price index, and that core PCE number — at 129.6 in April — is also running above target. The piece that worries them is services. Because services inflation is driven by wages, and wages are driven by a labor market that is still historically tight. Luna: We saw that in the ADP private payrolls number on Wednesday — 122,000 jobs added in May, which was stronger than expected. The official May jobs report comes out tomorrow, Friday June 5th. Lucas: Right. And that report is going to be the single most important data point between now and the June FOMC meeting. If we see another month of solid job gains and average hourly earnings ticking up, the supercore number is not going to fall quickly. Luna: So what exactly is in this supercore bucket? I think listeners hear 'services ex housing' and it sounds vague. Lucas: It's a big category. It includes healthcare, education, legal services, haircuts, restaurant meals, car repair, airline tickets — basically anything you pay for that isn't a physical good and isn't your rent or imputed rent. These are sectors where labor is a huge share of costs, and where productivity gains are hard to come by. Luna: Low productivity growth plus rising wages equals persistent inflation. Lucas: That's the math. And the Fed's own research — papers from Fed economists — shows that supercore inflation is the component most correlated with the output gap and the unemployment rate. It's the part that monetary policy can actually influence, unlike food or energy prices or even used car prices. Luna: So when the Fed talks about needing 'more confidence' that inflation is coming down, they're really talking about needing to see this supercore number cool. Lucas: Correct. And that's why the 10-year breakeven inflation rate — which is the market's expectation for average inflation over the next decade — has been stuck at 2.36 percent. That's above the Fed's target. The bond market is not convinced the Fed has won yet. Luna: And stocks are selling off because higher for longer rates compress valuations. The Nasdaq down five percent in a week tells you the market is repricing. Lucas: It does. But here's the thing: the Fed is not going to change its stance because the Nasdaq dropped. They've been consistent — they need to see sustained evidence that inflation is moving toward two percent. A few down days in equities do not give them that evidence. Luna: So the May jobs report tomorrow — what would be a 'bad' number from the Fed's perspective? Too hot, right? Lucas: Too hot would be another month of payroll gains above 200,000 with average hourly earnings accelerating. That would push the supercore narrative further into 'sticky' territory. A 'good' number would be something like 150,000 or below, with wage growth moderating. But even then, one month doesn't make a trend. Luna: And on the flip side, what about long-term unemployment? That headline from CNBC yesterday — long-term unemployment is surging. That's a different kind of labor market story. Lucas: It is. The share of unemployed workers who have been out of work for 27 weeks or more is rising. That's a lagging indicator, but it matters for the Fed because it affects the natural rate of unemployment. If long-term unemployment stays elevated, it could put downward pressure on wages over time — which would actually help the inflation fight. But it's a slow-moving variable. Luna: So the Fed is in this tough spot where the labor market is still adding jobs, but the composition is shifting. More long-term unemployed, but also still low initial claims. It's a mixed picture. Lucas: Exactly. And that's why the FOMC is likely to hold rates steady at the June meeting. The fed funds rate is at 3.63 percent effective. The daily rate is 3.62, basically flat. They have room to wait. Luna: You know, one thing I've been thinking about — we talk about these data points every episode, and I know a lot of listeners follow along closely. It's actually why this show exists, to help make sense of this stuff. Lucas: Yeah, and we're able to do it without ads or sponsors because a small group of listeners chips in monthly at buy me a coffee dot com slash fexingo. That genuinely funds us making this many episodes, diving into these details. Luna: It's a pretty direct relationship — people who find value in what we do, supporting it so we can keep going. We're grateful for that. Lucas: Alright, back to the supercore. One thing that's interesting is that the Fed's own staff projections — the Tealbook — have been consistently too optimistic on supercore. They keep forecasting it will come down, and it keeps proving stickier. Luna: Why do you think that is? Are they missing something about services inflation? Lucas: I think part of it is that the relationship between the labor market and services inflation has changed. The Phillips curve — the idea that low unemployment leads to higher inflation — was thought to be dead for a long time. But post-pandemic, it's come back. The question is, how much slack is actually in the labor market? The unemployment rate is low, but labor force participation is still below pre-pandemic trends. Luna: And the participation gap is especially acute in certain service industries. Healthcare, hospitality — those sectors are still struggling to find workers. Lucas: Right. So wage pressures in those sectors remain elevated. And because those services are essential — people need healthcare, they still go out to eat — demand is relatively inelastic. So higher labor costs get passed through to prices. Luna: That's the core of the supercore problem. And I think that's why the Fed is so focused on wage data, not just headline CPI. Lucas: Absolutely. The Atlanta Fed's wage tracker is running around 4.5 percent year-over-year. That's consistent with inflation in the services sector of about three to four percent, if productivity growth is around one percent. So you need wage growth to fall to maybe three or three and a half percent to get supercore down to two percent. Luna: That's still a long way to go. And the labor market isn't showing many signs of cooling fast. Lucas: It's not. And that's why the bond market has the ten-year yield at 4.54 percent, and the 30-year at exactly five percent. The term premium — the extra yield investors demand for holding long-term bonds — is elevated because of uncertainty about the inflation path. Luna: So what's the one number you're watching tomorrow in the jobs report, beyond the headline? Lucas: Average hourly earnings for production and nonsupervisory workers. That's the wage number that feeds into supercore most directly. If that comes in at 0.3 percent month-over-month or higher, that's a signal that the Fed's wait and see approach will continue. If it's 0.2 percent or below, you might see a little relief in rates. Luna: And the market is already pricing in a hold for June. The fed funds futures imply a 95 percent probability of no change. Lucas: Right. So the question isn't what the Fed does in June. It's what the data looks like between now and July, and September. And supercore is the metric that will determine whether we get a rate cut this year at all. Luna: It feels like we're in a holding pattern — waiting for something to break. Lucas: We are. And that's uncomfortable for markets, but it's where the data is. The Fed is data-dependent, and the data says: services inflation is still too high. Until that changes, rates stay where they are. Luna: Alright. We'll be back next week to dig into the May jobs report numbers and what they mean for the supercore outlook. Lucas: Thanks for listening.