Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / What the Fed Makes of Sticky Services Inflation
Transcript
- Lucas: So the May CPI came in this week, and the headline number was basically in line — 3.2 percent year-over-year, a tenth above April. But the thing that caught my eye, and I think the Fed's eye, was core services inflation, which actually ticked up. Luna: Right, because services have been the stubborn piece all year. Goods inflation has cooled off, but services keep hanging around. Lucas: Exactly. And within services, the Fed has this favorite subcategory they watch — core services excluding housing. That's the stuff like medical care, auto repair, haircuts, legal fees. That number rose 0.3 percent month-over-month in May, which annualizes to about 3.6 percent. Luna: And the Fed's target is two percent, so that's almost double. What's driving it? Lucas: A few things. One is that services are much more labor-intensive than goods. Wages are still growing around 4 to 4.5 percent, and when you're paying people more, the cost of their services goes up. The other factor is that tariffs — even though they directly hit goods — end up feeding into services too, because things like shipping, warehousing, and retail margins all get repriced. Luna: So the tariff story doesn't just stay in goods. It leaks into the service economy. Lucas: It does. And we're seeing it in the data. The Atlanta Fed's sticky CPI measure, which tracks prices that change slowly, is running at about 4.1 percent year-over-year. Compare that to the flexible CPI, which is more like minus 0.2 percent. The gap is enormous. Luna: That's the biggest divergence since the early '80s, I think. Lucas: It is. And what it tells the Fed is that the inflation problem has shifted from supply chain driven goods inflation to domestically-driven services inflation. That's a harder problem to solve with interest rates, because services are less sensitive to rate changes. Luna: So the Fed can raise rates, but it takes longer to cool off something like medical insurance premiums or rent. Lucas: Rent is actually a good example. Shelter inflation — that's the housing component — is still running around 5 percent year-over-year. But the market data from places like Zillow and Apartment List shows that new lease prices are barely rising. So there's a lag. The official CPI rent measure is catching up to the real world slowly. Luna: Which means shelter inflation should keep drifting down over the next six to twelve months, all else equal. Lucas: Right. But the core services ex-housing number — that's the one the Fed is really watching now. If that stays elevated, it's hard for them to declare victory on inflation. Luna: And it's not just the level, it's the persistence. We've been stuck around 3.5 to 4 percent for a year now. Lucas: That's exactly right. And that's why the market is now pricing in a lower probability of rate cuts this year. The fed funds futures are showing maybe one cut in November, and even that's not certain. Luna: Which is a big shift from January, when the market was pricing in four cuts. Lucas: Huge shift. And the breakeven inflation rate — the ten-year breakeven is at 2.36 percent, basically flat. That means bond traders aren't expecting inflation to collapse, but they also aren't expecting it to spike. It's this grinding, stuck feeling. Luna: You know, if walking through the economy with us has made something click — a chart, a policy move, whatever — there's a way to keep this going. Buy me a coffee dot com slash fexingo. A couple bucks a month genuinely makes a difference for a show like this. Lucas: Yeah, it's small amounts from people who find it useful. That's what keeps it ad-free and focused on the data. Luna: Exactly. So back to the Fed — what would it take for core services ex-housing to actually come down? Lucas: The big one is the labor market. If wage growth slows to 3 percent or below, that would directly feed into lower services inflation. The ADP data last week showed private payrolls grew by 122,000 in May, which is pretty moderate. That could be a sign that the labor market is cooling. Luna: But the official jobs report is out Friday, and that's the one the Fed really watches. Lucas: Right. The consensus is for around 180,000 nonfarm payrolls. If it comes in significantly lower, that could shift the narrative. But if it's hot — say, above 250,000 — then the Fed stays on hold. Luna: And the other factor is productivity. If companies can absorb higher wages through productivity gains, services inflation doesn't have to spike. Lucas: That's a big if. Productivity growth has been decent — around 2 percent — but not enough to fully offset 4 percent wage growth. So the math doesn't quite work yet. Luna: So what's the Fed's message right now? Are they dovish or hawkish? Lucas: I'd say they're data-dependent, but with a hawkish tilt. Chair Powell has been clear that they need to see a sustained improvement in services inflation before they cut. And we haven't seen it yet. Luna: So the next few CPI reports are crucial. If core services ex-housing stays at 0.3 percent month-over-month, no cuts. If it drops to 0.1 or 0.2, the door opens. Lucas: Exactly. And the market is watching the same thing. That's why the ten-year yield has been stuck around 4.5 percent — it's waiting for a signal. Luna: One thing that could change the calculus is the tariff escalation. If tariffs on services start to appear — like on digital services or insurance — that could push services inflation higher directly. Lucas: That's a good point. The U.S. just proposed fresh tariffs on 60 economies over forced labor trade practices. Most of that is goods, but if it broadens, services would be next. And central banks hate tariffs because they're a supply shock that tightens policy. Luna: So services inflation is the key variable for the second half of 2026. And right now, it's not cooperating. Lucas: It's not. But the Fed has time. They've already paused since January. They can afford to wait and see if the lagged effects of previous rate hikes — and the cooling labor market — eventually bring services inflation down. Luna: The risk is that if they wait too long, the economy could tip into a recession. That's the classic tightrope. Lucas: It is. And that's what makes this moment so interesting. The data is ambiguous. The market is uncertain. And the Fed is trying to thread the needle. Luna: Let's see what Friday's jobs report tells us. Lucas: Yeah, that'll be the next big piece of the puzzle.