Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Worried About the Services Supercycle
Transcript
- Lucas: So the phrase 'services supercycle' has been popping up in central bank speeches for about eighteen months now, and I think it's worth unpacking exactly what it means — because it's not just a fancy label for 'services are expensive right now.' Luna: Right, it implies something structural, something that persists through the normal business cycle. But I still hear people use it interchangeably with just high services inflation. Lucas: Exactly. And that's the confusion. A supercycle doesn't mean a spike — it means a regime shift. Think about the euro area in early 2025. Headline inflation had come down nicely from the 2022 peaks, but services inflation was sitting at 4.1 percent. Goods inflation was near zero. That gap persisted quarter after quarter. Luna: Four-point-one percent is well above the ECB's two percent target. So that alone would keep rates higher for longer. Lucas: It does. And the ECB's own staff projections at the time had services inflation declining only slowly — still above three percent through the end of 2025. That's the supercycle logic: services prices are stickier because they're driven by labour costs, not by global commodity prices or supply chains. You can't just import cheaper services the way you can import cheaper electronics. Luna: And labour costs are persistently driven by tight labour markets. In the euro area, unemployment was at historic lows in 2025 — below six and a half percent in many countries. Lucas: That's the structural floor. Wages in services sectors — hospitality, healthcare, personal services — they don't fall when demand softens. They ratchet up. And because services are labour-intensive, that wage growth feeds directly into prices. The ECB estimated that each percentage point of wage growth added about three-tenths to services inflation. Luna: So you get this self-reinforcing loop: tight labour market pushes wages up, which pushes services prices up, which keeps real wages from rising too much, which keeps the labour market tight. Lucas: That's the wage-price spiral everyone was worried about in 2022 — but it never really materialised in goods because goods prices are set globally. In services, it's local. And that local dynamic is what makes it a supercycle. It's not a one-off shock; it's a multi-year adjustment to a new equilibrium. Luna: So what caused the shift? Was it just post-pandemic catch-up, or is there something deeper? Lucas: I think it's deeper. Demographics play a role. Ageing populations in Europe and Japan mean more demand for healthcare and elder care services, which are labour-intensive and have low productivity growth. That pushes up the relative price of services. The Bank for International Settlements published a paper in 2024 showing that ageing alone could add half a percentage point to services inflation annually in advanced economies over the next decade. Luna: Half a point per year from demographics alone. That's big. And central banks target two percent overall. Lucas: Right. So the implication is that the neutral rate — the rate that neither stimulates nor restricts the economy — may be higher than pre-pandemic estimates. If services inflation is structurally higher, you need a higher real rate to keep aggregate demand in check. That's why the ECB, the Fed, and the Bank of England have all been revising their estimates of r-star upward. Luna: But is this a universal phenomenon? The US services inflation story looks different from Europe's, doesn't it? Lucas: It does. US services inflation peaked earlier and came down faster, partly because the US labour market cooled a bit more quickly — but also because US productivity growth in services has been stronger, especially in tech-enabled sectors like retail and finance. Europe has more traditional services with lower productivity growth. Luna: So the supercycle is more acute in Europe. But the concept still applies globally. Lucas: Absolutely. And it's not just about the level of inflation — it's about the composition. Central banks used to focus on core inflation excluding food and energy. But now they're increasingly looking at a 'core services' sub-index. The Fed's preferred measure, the core PCE, has a services component that's nearly two-thirds of the index. If that component runs hot, the overall number stays elevated. Luna: And that changes the policy conversation. It's not about whether inflation is transitory or persistent — it's about whether the structural drivers are shifting. Lucas: Exactly. And one of the most interesting developments is how central banks are communicating this. In early 2026, ECB President Lagarde gave a speech where she explicitly used the term 'services supercycle' — and she tied it to the need for a more gradual approach to rate cuts. She said, and I'm paraphrasing, that the nature of inflation had changed and that policy needed to be 'patient and data-dependent'. Luna: Which is central banker code for 'we're not going to cut as fast as you'd like.' Lucas: Exactly. But it's also a signal that they see this as a long-term phenomenon. And that has real consequences for borrowers, for businesses, for anyone with a mortgage tied to variable rates. If the neutral rate is structurally higher, the era of ultra-low rates is not coming back anytime soon. Luna: Let me push back a little. Some economists argue that the services supercycle is just a lag effect from the pandemic — that as people rebalance their consumption back toward goods, services inflation will fade naturally. Lucas: That's a fair argument. And it could be true. But the data so far doesn't support it. Even as goods consumption normalised in 2024 and 2025, services inflation remained sticky. The rebalancing argument assumes that services prices are just catching up to goods prices, but the catch-up should have happened by now. The fact that it hasn't suggests something more structural. Luna: There's also the housing component. Rent and owners' equivalent rent are both services, and they've been stubbornly high in many countries. Lucas: Housing is a huge part of it. In the US, shelter makes up about a third of the CPI. And shelter inflation is slow to adjust because leases reset slowly. But again, that's structural — it's tied to housing supply constraints, not to monetary policy. Central banks can't build more apartments. Luna: So what can they do? If the supercycle is structural, raising rates might not bring services inflation down much — it would just crush demand in other parts of the economy. Lucas: That's the central bankers' dilemma. If you raise rates enough to significantly slow services inflation, you risk a recession. If you don't, you risk de-anchoring inflation expectations. The ECB and the Fed have both chosen a middle path — keeping rates restrictive but not aggressively so, and signalling that they'll cut slowly. Luna: It feels like they're trying to thread a very narrow needle. Lucas: They are. And it's not just about the level of rates — it's about the path. Markets in mid-2026 are pricing in a gradual easing cycle, but with a higher terminal rate than before the pandemic. The ten-year Treasury yield has been hovering around four percent, which is well above the sub-two percent levels of the 2010s. Luna: And that higher term premium reflects the supercycle risk — investors demanding more compensation for holding long-term bonds because they see persistent inflation risk. Lucas: Exactly. And that brings us back to the core idea: the services supercycle is really a story about the structural drivers of inflation. It's demographics, it's productivity, it's labour market tightness. Monetary policy can lean against it, but it can't fix the underlying causes. Luna: So where does that leave us? Are we just stuck with higher inflation forever? Lucas: Not forever, but for the foreseeable future. The key is that the inflation target is two percent. If services inflation is running at three or four percent, something else has to give — either goods prices fall, or the overall index stays above target. Central banks have to decide how much tolerance they have for that. Luna: And that's where the debate gets interesting. Some policymakers have floated the idea of a higher inflation target, maybe three percent. But that's a politically explosive idea. Lucas: It is. And central bankers have been very careful not to go there. But privately, many economists think that if the supercycle persists, the target will have to be re-evaluated. Not now, maybe not for five years, but eventually. Luna: It's a fascinating shift. The whole framework of inflation targeting was built in a world where goods inflation was the main driver, and services were a lagging indicator. Now it's the other way around. Lucas: And that means the tools have to evolve too. Macroprudential policy, fiscal policy, supply-side reforms — they all become more important when monetary policy is constrained by structural inflation. It's not just about interest rates anymore. Luna: Speaking of the show evolving — and I hate to interrupt this thread — but it occurs to me that if walking through the economy with us has made something click for you, a couple of dollars a month is genuinely what keeps these episodes going. Buy me a coffee dot com slash fexingo. It's a small thing that makes a real difference for us. Lucas: Yeah, we hear from listeners who say they use these episodes to understand the world better — and that's exactly why we do it. So if you've gotten something out of it, that link is buy me a coffee dot com slash fexingo. No pressure, just an option. Luna: Alright, back to the supercycle. One thing I've been wondering about is how this plays out in emerging markets. Do they face the same structural forces? Lucas: Great question. In many emerging economies, the services share of GDP is smaller, but it's growing fast. And they have even more demographic pressure — younger populations mean more demand for education and healthcare. But they also have higher productivity growth potential in services because they can leapfrog with technology. Luna: So it's not a one-size-fits-all story. The supercycle is real, but its shape depends on the structure of the economy. Lucas: Exactly. In India, for example, services inflation has been running hot, but it's driven by housing and transport, not by wages. In Brazil, it's more about indexation and inertia. So central banks have to tailor their response. Luna: And that's the challenge — recognising that the old models might not apply, but not overreacting to what might be a transitory shift. Lucas: Right. And the best we can do is watch the data, especially the wage data and the services inflation prints. If those start to decelerate, then maybe the supercycle narrative fades. But if they stay elevated, we're in for a longer adjustment. Luna: It feels like the next few quarters will be decisive. Lucas: They really will. The ECB's September 2026 projections, the Fed's December 2026 dot plot — those will tell us whether central banks see this as a supercycle or just a slow rebalancing. Either way, it's the most important story in monetary policy right now. Luna: And we'll keep following it. Thanks for listening. Lucas: We'll be back next week with another deep dive.