Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why Services Inflation Is The Fed's Real Problem
Transcript
- Lucas: If you look at the headline consumer price index for August, it came in at 334.1, which is a tick up from July but barely moves the needle. Most of the media will tell you that inflation is tamed because energy prices have stabilized and used car costs are finally normalizing. But if you dig into the components, specifically the services sector, the picture looks significantly more congested. Luna: Right, and with the core PCE still sitting at 130.7, we are seeing that the easy wins on disinflation are already banked. The hard part is always the labor-intensive services where you can't automate away the cost. Lucas: Exactly. And that is why the Federal Reserve is likely to hold steady or even consider a cautious pause rather than cutting aggressively next week. The latest headlines suggest the likelihood of a rate hike or a prolonged hold just got higher, largely because services inflation refuses to behave like goods inflation. It is structural, not cyclical. Luna: So when you say structural, are we talking about the wage pressures pushing those service costs up, or is it something else entirely? Lucas: It is a combination, but let's start with wages. Average hourly earnings for private workers hit 37.8 dollars in August, up from 37.65 dollars the previous month. That might sound small, but when you compound that across the entire services sector—think healthcare, hospitality, and professional services—it creates a persistent floor under prices. Employers aren't just paying more; they are passing those costs directly to consumers because demand remains relatively inelastic. Luna: And with job openings still up at 7,271 thousand in the JOLTS report, there is still plenty of competition for workers. Does that mean we are stuck in this high-wage, high-price loop for the foreseeable future? Lucas: We are definitely in a zone where the labor market is too tight to allow for rapid disinflation. The unemployment rate is holding at 4.10 percent, which sounds benign until you look at the nonfarm payrolls adding 159,075,000 jobs last month. That kind of sustained hiring keeps upward pressure on wages, and consequently, on the prices of services like legal advice, home repair, and medical care. Luna: I remember when everyone was betting on a quick return to two percent inflation back in early 2024. Why did that assumption fail so spectacularly on the services side? Lucas: Because markets were focused on goods, particularly durables. Once supply chains healed and inventory levels normalized, goods prices dropped like a stone. Services, however, are delivered by people. And people get raises. So while your electricity bill might stabilize, the cost of getting your hair cut, fixing your roof, or seeing a specialist doctor continues to creep up. It is a classic case of Baumol's cost disease playing out in real time. Luna: Baumol's cost disease—the idea that productivity gains in manufacturing don't translate to services like education or healthcare. So the Fed can't just wait for supply shocks to fix itself here. Lucas: Precisely. You cannot print more barbers or doctors overnight. The constraint is human capital. And looking at the ten-year breakeven inflation rate, which just ticked up to 2.40 percent, the bond market is pricing in that this stickiness will persist longer than the Fed would like. Investors know that services inflation is harder to kill than goods inflation. Luna: It feels like the Fed is walking a tightrope. If they cut rates too fast, they risk re-igniting those service prices. But if they keep them high, they risk choking off the labor market. Lucas: That is the dilemma. The real GDP growth figure for the second quarter came in at 1.50 percent annualized, down from 2.10 percent. The economy is slowing, but it isn't crashing. That 'goldilocks' stagnation is actually the worst-case scenario for the Fed because it allows inflation to linger without triggering the recessionary pain that usually forces prices down. Luna: So we are in a holding pattern where the Fed waits for either a clear drop in services prices or a significant softening in employment data. Which one do you think hits first? Lucas: I think the employment data will soften first. Look at the initial jobless claims—they dropped slightly to 206,000, but the trend is flattening. As the lagged effects of previous rate hikes fully bite, businesses will stop hiring as aggressively. When hiring slows, wage growth moderates, and eventually, service providers lose their pricing power. But that transmission mechanism takes time, often six to nine months. Luna: Which brings us right back to this week's FOMC meeting. Given the August CPI print, are you expecting any language changes in the statement, or is it business as usual? Lucas: Expect business as usual, which means cautious neutrality. The Fed needs to see more evidence that the core PCE is trending down before they commit to cuts. With the PCE price index at 131.7 and core PCE at 130.7, we are still above their comfort zone. They will likely emphasize the need for further progress on inflation before considering any policy adjustments. Luna: It seems frustrating for consumers who feel the pinch every day at the grocery store or the gas pump, only to hear officials talk about long-term trends. How does the public reconcile that gap? Lucas: They don't, and that is a political problem as much as an economic one. The consumer sentiment survey plunged in September, largely because inflation expectations worsened. People vote with their wallets, and if they feel prices are rising faster than their incomes, they pull back. That pullback is what the Fed ultimately wants, but it hurts in the short term. Luna: So the Fed is essentially asking Americans to endure a bit more discomfort to ensure that the victory over inflation is permanent. Do you think they have the credibility to ask for that patience? Lucas: Their credibility is intact, but it is fragile. Every time a hot inflation print comes out, the market sells off and yields spike. The S&P 500 dropped 0.6 percent over the last five days, and the Dow fell 1.4 percent. Markets are nervous about the Fed losing control of the narrative. They need to signal that they see the data clearly. Luna: And with the ten-year Treasury yield climbing to 4.96 percent, the financial conditions are tightening on their own. Isn't that enough of a brake on the economy? Lucas: It is a factor, but mortgage rates and corporate borrowing costs are sensitive to that yield curve. Higher yields make it harder for businesses to invest and for homeowners to refinance. It adds friction to the system. But it doesn't directly address the wage-driven inflation in services. That requires a cooldown in the labor market, which higher rates alone might not achieve quickly enough. Luna: So we are watching a battle between monetary policy and structural labor dynamics. What should investors be watching in the coming weeks to gauge which side wins? Lucas: Watch the hourly earnings reports and the sector-specific price indices. If you see healthcare and housing services decelerating, then the Fed can relax. If those sectors remain flat or rise, expect rates to stay higher for longer. The devil is in the details of the services basket. Luna: It makes sense to look past the headline number and focus on where the money is actually changing hands. Thanks for breaking that down, Lucas. Lucas: Anytime, Luna. Let's take a quick break to acknowledge our listeners. If walking through the economy with us has made something click, and you want to help keep these daily conversations ad-free, honestly, if today was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. Luna: Yeah, your support literally fuels the research that goes into these deep dives, so we appreciate it. Lucas: Back to the macro landscape. One final thought on the Fed's dilemma: they are trying to engineer a soft landing in an environment where the ground is shifting. The key is whether the labor market cools gently or snaps. We are closer to the latter than most analysts admit. Luna: A gentle landing or a hard stop—that is the question hanging over every portfolio this quarter. Lucas: Exactly. And until the services inflation data turns decisively lower, the Fed will remain on high alert. We will see you tomorrow for another look at the numbers.