Latest / Inflation Explained with Fexingo: CPI, Prices, and the Cost of Living for Everyday People / Why the Fed Is Stuck Between Core Services Inflation and Rate Cuts
Transcript
- Lucas: So the new Fed chair, Kevin Warsh, just wrapped up his first meeting earlier this week, and the statement was pretty much what everyone expected — rates on hold, no rush to cut. But the question nobody's really getting a straight answer on is: why is core services inflation so stubborn? Luna: It's the piece of the puzzle that keeps the Fed from declaring victory, right? Because goods inflation has fallen, energy's come down — but services, the stuff we spend most of our money on, is still sticky. Lucas: Exactly. And when I say core services, I mean everything that's not housing, not food, not energy. Think medical care, auto insurance, haircuts, streaming subscriptions, legal fees — the labor-intensive parts of the economy. The May CPI report, which came out earlier this month, showed core services inflation running at about 4.6 percent year-over-year. Luna: That's almost double the overall CPI rate, which was 4.2 percent. So the headline number is cooling, but the engine underneath is still hot. Lucas: Right. And the Fed's preferred gauge, the PCE price index — that's the one they target — actually came in at 2.7 percent for April, the most recent reading. But core PCE, which strips out food and energy, was 2.8 percent. Still above the 2 percent target, and the services component is the reason. Luna: So when Warsh says 'we need more data,' what he really means is he's waiting for services inflation to crack. But what would have to happen for that to actually materialize? Lucas: Good question. Services inflation is largely driven by labor costs. Wages in service industries have been growing around 4 to 5 percent a year. And because services are less automated than goods production, those wage increases get passed straight through to prices. So until the labor market softens meaningfully, services inflation stays elevated. Luna: But we've seen some softening in the job market — the unemployment rate ticked up to 4.1 percent in May. Isn't that the kind of slack that should cool wage growth? Lucas: It should, in theory. But the service sector is still adding jobs, and quit rates — a sign of worker confidence — are still above pre-pandemic levels. People are switching jobs for better pay, and that keeps upward pressure on wages. So the transmission from a slightly higher unemployment rate to lower services prices takes time. Luna: And meanwhile, the bond market is pricing in a different story. The 10-year breakeven inflation rate — that's the market's expectation of average inflation over the next decade — fell to 2.25 percent this week. That's down from 2.26, but it's been hovering right around there for months. Lucas: Yeah, and that's actually a crucial signal. The breakeven rate tells you what bond traders think inflation will be, and 2.25 is pretty close to the Fed's 2 percent target. But the Fed looks at the actual data, not just market expectations. And the actual data shows core services inflation stuck above 4 percent. So the market is betting the Fed will eventually cut, but the Fed is saying, 'We need to see it in the numbers.' Luna: So there's this disconnect. And I think this gets to something a lot of our listeners are feeling: their own cost of living isn't matching the headline CPI number. Because if you're paying more for car insurance — which was up 19 percent year-over-year in May — or your health insurance premium went up, or your kid's daycare costs more, that's services inflation. And it's eating your paycheck even if gas prices are lower. Lucas: That's exactly the point. The CPI headline number is an average. And the services that are rising fastest are the ones you can't easily substitute. You can't decide to stop going to the doctor or drop your auto insurance because rates are high — not if you want to drive legally. So that's where the pain is concentrated. Luna: And that's the part of inflation that the Fed's interest rate tools are least effective at fighting, right? Because raising rates cools demand for houses and cars and durable goods, but it doesn't directly slow down the cost of a haircut or a doctor's visit. Lucas: Exactly. Monetary policy works with a lag, and it works through interest-sensitive sectors. Services are less interest-sensitive. So even if the Fed keeps rates at 3.63 percent — which is where they are now — it takes a long time for that to feed through into slower service-sector wage growth and price increases. Luna: And that's why Warsh and the FOMC are content to wait. They don't want to cut prematurely and then have to reverse course. But the longer they wait, the more pressure on consumers and on parts of the economy that are already slowing — like small business borrowing, which is down significantly. Lucas: Right. And this is actually where the conversation gets really interesting, because the data we're talking about — CPI, PCE, breakeven rates — it can feel abstract. But if walking through the economy with us has made something click for you, I want to mention something. We deliberately don't run ads on these episodes. No sponsors, no mid-roll interruptions. It's just us talking through the numbers. Luna: And that's a choice we've made — we think it makes the conversation cleaner. But it does mean the show relies on listeners who find value in it. If that's you, and you want to support that ad-free approach, there's a link: buy me a coffee dot com slash fexingo. No pressure, just an option. Lucas: Yeah, exactly. And it genuinely helps. So, back to the Fed's bind — because I think there's another layer here. Warsh is new, and he's inheriting a committee that's divided. Some members want to cut now to avoid overtightening. Others are hawkish and want to see core services inflation below 3 percent before they even discuss cuts. Luna: And the dot plot — the Fed's projections — from this week's meeting showed the median expectation for one or two cuts by the end of the year. But that's down from three cuts projected back in March. So the committee is shifting toward patience. Lucas: Right. And the market is now pricing in the first cut at the September meeting, with maybe another in December. But if core services inflation doesn't budge over the summer, that timeline gets pushed out. And then you have to ask: what's the cost of waiting too long? Luna: The risk is that the economy slows more than expected, and the Fed ends up behind the curve. We're already seeing some weakness in the Russell 2000, the small-cap index — it's down about 0.9 percent over the past five days. Small businesses are more sensitive to interest rates. Lucas: Yeah, and the broader market is trading near all-time highs — the S&P 500 at 7,501, the Dow at 51,565 — but that's being driven by a handful of mega-cap tech stocks. The average stock isn't doing as well. So there's a divergence between the headline market and the real economy. Luna: And that divergence mirrors what we're seeing in the inflation data: headline CPI looks okay, but core services tells a different story. So the Fed is stuck, the market is optimistic, and consumers are stuck in the middle. Lucas: Exactly. And that's the bind. The Fed can't cut until services inflation eases, but services inflation won't ease until the labor market softens more, and if the labor market softens too much, the economy could tip into recession. So Warsh is walking a tightrope. Luna: And the data over the next two months — June and July CPI, PCE, and especially the employment cost index — will be the deciding factors. If we see services inflation start to dip, the September cut becomes more likely. If it stays sticky, we're looking at no cuts until 2027. Lucas: I think that's the right framework. And for our listeners, the takeaway is: don't just look at the headline inflation number. Look at the components. If your personal inflation rate — the things you actually spend money on — is higher than the official CPI, you're not imagining it. It's because services, which are a big part of your budget, are rising faster than the average. Luna: And that's the lens we'll keep using. Next week, we'll dig into one specific service category that's been a surprise driver — auto insurance, which we touched on briefly, but we'll go deeper on why rates are up 19 percent and whether there's any relief in sight. Lucas: Good plan. For now, the key number to watch is that core services CPI print in July. If it stays above 4 percent, the Fed stays put. If it dips below 4, the conversation changes. We'll be watching.