Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / The Fed's Growing Unease About Sticky Wage Inflation
Transcript
- Lucas: The May CPI print landed at 4.2 percent annual — highest in three years — and the immediate reaction was all about energy. Oil spiking on the Iran situation, gasoline up 8 percent month-over-month. That's the headline. But what I think the Fed is quietly more worried about is the stuff that doesn't show up in the headline. Luna: You're talking about the core services number, right? Because core CPI ex food and energy was still 3.6 percent annualized. Lucas: Exactly. And within that, the real stubborn piece is what the Fed calls 'supercore' — services excluding housing and energy. That number is running around 4.5 percent. And the biggest driver there? Wages. When you pay people more to mow lawns, fix plumbing, or serve lunch, those costs get passed through as higher prices. And unlike a gasoline spike, wage inflation tends to be sticky. Luna: Sticky because it's hard to cut wages once they go up. Companies don't announce pay cuts. Lucas: Right. So the Fed is watching the Employment Cost Index — the ECI — which came out for Q1 at 3.8 percent year-over-year. That's down from the peak of 5.1 percent in 2022, but it's plateaued. It's been hovering around that 3.8 to 4 percent range for three quarters now. And the Atlanta Fed's wage tracker is showing something similar — about 4.0 percent for job switchers, 3.6 for stayers. Luna: So even if goods inflation cools — and it has, slightly — services inflation stays elevated because wages aren't coming down. That puts the Fed in a tough spot. Lucas: It does. Because the usual playbook would be: oil spike is transitory, look through it, focus on core. But core is being propped up by wage growth that is itself being driven by a labor market that still has more job openings than available workers. The latest JOLTS data had about 1.2 openings per unemployed person. That's above what the Fed considers 'normal.' Luna: And this is where it gets interesting — the Fed is also seeing consumer inflation expectations tick up. The 10-year breakeven is at 2.32 percent, which is low historically but up a bit from last month. If people expect higher prices, they demand higher wages, and that becomes a self-fulfilling cycle. Lucas: That's the feedback loop the Fed fears most. Chair Powell has used the phrase 'wage-price spiral' a few times — usually to say we're not in one yet. But the longer wage growth stays above 3.5 percent with productivity growing around 1.5 percent, the more pressure builds on unit labor costs. That's what shows up in the PCE deflator, which is the Fed's preferred measure. The core PCE is running at 2.8 percent — still above the 2 percent target. Luna: And that's why the market is pricing in maybe one rate cut this year, not the four that were expected back in January. The dot plot coming out of the June FOMC meeting probably reflects that. Lucas: Which brings us to a subtle point. The Fed is trying to distinguish between energy-driven inflation and demand-driven inflation. Energy is a supply shock — the Iran conflict disrupted shipping lanes, pushed up crude. That's not something monetary policy can fix. But wage-driven services inflation is demand-side. Higher rates are supposed to cool demand, which slows hiring, which pressures wages down. Luna: But it hasn't worked yet. The labor market is still tight. And the Fed has to be careful not to over-tighten and break something, especially with the small-cap rally we've seen — the Russell 2000 is up 2.7 percent in five days. That's risk-on behavior, which suggests markets don't believe the Fed will stay hawkish. Lucas: And that's the tension. The Fed wants to see wage growth moderate to maybe 3 percent to feel confident inflation is sustainably heading to 2 percent. But the data keeps coming in around 3.8. So they're stuck. They can't cut without seeing more progress, but holding rates high for longer risks tipping the economy into recession, especially if the energy shock broadens. Luna: Some of our listeners might wonder — if the Fed is so worried about wages, why not just raise rates more aggressively? They have room — the fed funds rate is at 3.63 percent, still below the CPI rate. Lucas: That's the question. The answer is that the Fed thinks the neutral rate — the rate that neither stimulates nor restricts — has probably risen. Estimates from the New York Fed put it around 2.5 to 3 percent. So current rates aren't as restrictive as they seem. But raising rates now, with oil shocks and global uncertainty, could be like stepping on the brake when the road is already icy. Luna: So they're going to wait. And watch the next few months of ECI and CPI data. And hope that the wage growth trend breaks. Lucas: Exactly. And that's why this episode's focus on wages matters. It's the slow-moving part of inflation that doesn't make headlines but keeps the Fed up at night. Luna: If walking through the economy with us has made something click — maybe a concept you hadn't fully connected — that's exactly why we do this show ad-free. No sponsors, no commercials, just a conversation about what the data actually says. Lucas: 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. No pressure, but it helps us keep doing this. Luna: Yeah, it's a small way to keep the podcast independent. And we appreciate everyone who's already chipped in. Lucas: So back to the wage story. Let's talk about one specific sector where this is showing up: healthcare. The latest data from the Bureau of Labor Statistics shows healthcare employment is still running hot — 50,000 jobs added per month. And wages in that sector are up 4.2 percent year-over-year. Luna: Healthcare is a huge part of services inflation because it's labor intensive. You can't offshore a nurse or automate a home health aide. Lucas: Right. And what's interesting is that the Fed has started talking more about productivity in this context. If wage growth is running at 3.8 percent but productivity is growing at 1.5 percent, then unit labor costs are rising about 2.3 percent — which is above the Fed's comfort zone. But if AI or other efficiency gains push productivity to 2 percent or more, that same wage growth suddenly becomes consistent with 2 percent inflation. Luna: So the Fed is hoping for a productivity miracle? That seems like a thin reed to lean on. Lucas: It is. But it's not entirely fantasy. We saw a productivity surge in 2023 and 2024 — about 2.5 percent growth — driven partly by remote work efficiencies and automation. That's faded to around 1.5 percent. The question is whether the AI wave can boost it again. Some economists think yes, but it'll take time. Luna: And in the meantime, the Fed just has to sit tight. Which brings us back to the FOMC meeting this week. Any expectations? Lucas: Almost certainly no rate change. The fed funds rate stays at 3.63 percent. The statement will likely acknowledge the inflation stickiness and the geopolitical risks. The dot plot might show fewer cuts than the market expects — probably one cut in the second half of 2026, if that. Luna: So the key takeaway for listeners: the Fed is watching wages more than oil. And as long as the labor market stays tight, rates stay high. Lucas: Exactly. The next big data point will be the June jobs report, due July 2. If we see average hourly earnings come in below 3.5 percent, that would be a signal that wage growth is finally cooling. If not, the Fed's wait and see approach continues. Luna: And we'll be here to break it down. That's it for this episode of The Federal Reserve Podcast with Fexingo. Lucas: Thanks for listening. We'll catch you next time.