Latest / Inflation Explained with Fexingo: CPI, Prices, and the Cost of Living for Everyday People / Why the Fed Is Ignoring Rising Core Services Inflation
Transcript
- Lucas: So the Fed just held rates steady at Kevin Warsh's first meeting as chair, and the statement said inflation is 'easing.' But here's the thing — the data underneath is not as clean as that headline suggests. Luna: You're talking about the split between goods and services, right? Because goods prices are actually falling in some categories, but services keep climbing. Lucas: Exactly. May's CPI came in at 334.0, up from 332.41 the month before. That's a 4.2 percent annual rate on core — but strip out food and energy and core is still 4.2 percent. What matters is that almost all of that core increase is coming from services. Luna: And the Fed's preferred measure, the PCE, is a bit lower — core PCE was 129.6 in April, up from 129.32. Still a 2.8 percent annualized rate. But the Fed is looking through services. Why? Lucas: Because they're betting that the services inflation is lagged — that it's just catching up to the goods inflation we saw in 2021-2022. The theory is that as rents and insurance contracts reset, they'll eventually moderate. But that's a bet, not a certainty. Luna: And the 10-year breakeven rate — which is the market's expectation for average inflation over the next decade — has dropped to 2.26 percent as of yesterday. That's down from 2.29 last week. So bond traders are buying the Fed's story. Lucas: They are. But the breakeven is an average. It masks the fact that near-term services inflation is running way above that. My concern is that if services stay sticky, the Fed might have to hike again later this year — even as goods prices are flat or falling. Luna: Let's break down where the stickiness is. Rent of primary residence is still up about 5 percent year-over-year. Auto insurance is up double digits. Medical services are up around 3 percent. These are the items that hit households hardest. Lucas: Right. And they're the ones the Fed can't easily control with interest rates. Higher rates don't fix a shortage of apartments or make car repairs cheaper. So the Fed is essentially saying, 'We've done enough on goods, we'll wait for services to catch down.' That's a strategy, but it's risky. Luna: What's the risk? That waiting takes longer than expected, and inflation expectations become unanchored? Lucas: Exactly. If consumers start expecting 4 percent inflation year after year, they'll demand higher wages, businesses will pass those costs on, and we get a wage-price spiral. The breakeven rate suggests that's not happening yet — but the CPI data shows it's a live possibility. Luna: And there's a political angle too. Kevin Warsh is a new chair, appointed by a president who wants rates lower. If he tightens again to fight services inflation, he'll face pressure from the White House. If he doesn't, he risks letting inflation become entrenched. Lucas: That's the bind. The Fed's dual mandate is maximum employment and stable prices. Employment is strong — unemployment is around 3.8 percent. So the focus should be on prices. But services inflation is mostly driven by supply constraints, not excess demand. Luna: Give me an example of a supply constraint. Rent. Lucas: Rent. New apartment construction has slowed because of high material costs and labor shortages. So vacancy rates are low, landlords have pricing power. No amount of rate hikes builds more apartments. That's why some economists argue the Fed should look through rent inflation. Luna: But if they look through it, and rent stays high, that's a direct cost to households. It's not 'transitory' in the way the Fed thought in 2021. Lucas: Right. And that's the tension. The May CPI data showed that rent of primary residence rose 0.4 percent month over month. That's an annualized rate of almost 5 percent. So the Fed's 'wait and see' approach could mean a long period where real wages are squeezed. Luna: What about the goods side? Are there any bright spots? Lucas: Absolutely. Used car prices have fallen about 8 percent year-over-year. New car prices are flat to down. Apparel is down. Even some food categories are moderating. The problem is that goods are only about 25 percent of the CPI basket. Services are the other 75 percent. Luna: So even if goods deflation continues, it's not enough to bring overall inflation down to 2 percent unless services cooperate. Lucas: Exactly. And that's why the Fed's language matters. In the June 17 statement, they said inflation 'remains elevated' but added that 'progress has been made.' That's carefully balanced. They didn't declare victory, but they didn't signal a hike either. Luna: And the market reaction? Stocks are up, the S&P 500 is at 7,420, the Dow hit 51,493. So investors are interpreting the Fed as dovish. Lucas: They are. But I think they're reading the headline, not the details. The details suggest the Fed is taking a gamble on services. If that gamble pays off, great. If it doesn't, we could see a rate hike in September or December. Luna: Speaking of gambles, I want to come back to something you said earlier about wage-price spiral. Do we have any evidence that's starting? Lucas: Average hourly earnings are up about 4 percent year-over-year. That's above the pre-pandemic trend of 3 percent. But productivity growth has been decent — around 2 percent. So unit labor costs aren't surging. That's a good sign. But if productivity slows, wages could become a problem. Luna: So the key variable to watch is productivity. Lucas: And rent. And auto insurance. And medical costs. Honestly, there's a lot to watch. But the single most important number is the next CPI report in July. If core CPI stays above 4 percent, the Fed's patience will be tested. Luna: And if it drops below 4 percent, they'll probably stay on hold for the rest of the year. Lucas: Exactly. That's the pivot point. And speaking of making sense of the economy, if unpacking this stuff with us has made something click today, you can support the show. It's ad-free and listener-supported, so if today's episode was worth a coffee to you, there's a link — buy me a coffee dot com slash fexingo. Luna: Yeah, it genuinely helps us keep doing deep dives like this without any sponsor interruptions. And we really appreciate it. Lucas: So back to that pivot point — I think the wildcard is actually the global side. UK inflation held steady at 2.8 percent in May, and the UK economy shrank 0.1 percent in April. If Europe slows, that could drag down demand for goods and services, which would help the Fed's case. Luna: But it could also mean global supply chains tighten again if there's geopolitical disruption. The Iran situation is still fluid. Lucas: Right. Three Iranian tankers just exited a U.S. blockade. That's a sign that tensions are easing, but it could also mean oil prices stay volatile. Oil at $69 a barrel is actually helping keep headline inflation down. If that reverses, the Fed's job gets harder. Luna: So net-net, the Fed is in a holding pattern, but the altitude is shaky. Lucas: That's a great way to put it. They're cruising at 3.63 percent on the fed funds rate, hoping the tailwinds from goods deflation will eventually bring services down. But if the engines sputter, they'll have to climb again. And that climb will be painful for anyone carrying debt. Luna: Especially credit card debt, which is at an all-time high. Higher rates for longer would be a real squeeze. Lucas: It would. So the next six months are critical. We'll be watching every data release. And we'll keep breaking it down here.