Understanding the Federal Reserve's Concerns with Service Inflation
While America's overall inflation has seen progress, the persistence of service inflation poses a challenge. The Federal Reserve may need to prolong higher interest rates to address the continual rise in costs for services like haircuts and medical appointments.
America’s inflation problem has improved greatly in some respects — but it remains stubborn for the price of services. That means the Federal Reserve, which is tasked with stabilizing prices, could keep interest rates higher for longer if the rising costs of your haircut, your doctor’s visit and other services don’t abate soon.
Price growth has slowed steadily over the past year but it’s been a bit of a bumpy ride. For example, inflation in January didn’t slow as much as investors were expecting, largely due to persistent price pressures in housing and services.
Overall, consumer prices went up by 0.3% in January 2024 compared to December 2023, as reported in the most recent Consumer Price Index. This marks the largest monthly increase since September.
While inflation for goods saw a decrease, there were notable increases in the costs of services. Prices for medical care services and haircuts both rose by 0.7%. Additionally, insurance and financial services played a role in driving up overall consumer prices.
These trends were also reflected in the Federal Reserve's favorite measure of inflation - the Personal Consumption Expenditures price index. The report indicated that prices for services remained consistent at the start of the year.
Job seekers attend a Veteran Employment and Resource Fair in Long Beach, California, US, on Tuesday, Jan. 9, 2024.
Job seekers attend a Veteran Employment and Resource Fair in Long Beach, California, US, on Tuesday, Jan. 9, 2024.
Eric Thayer/Bloomberg/Getty Images
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Investors had high hopes for rate cuts in January after disappointing inflation readings. Wall Street even thought the Fed might cut rates up to six times this year. However, those expectations have now been thrown out the window.
The Labor Department is set to release its Consumer Price Index for February on Tuesday.
Before speaking with Saira Malik, chief investment officer at Nuveen, about the current situation regarding services inflation and its significance for the Fed, Before the Bell conducted an interview with her.
Please note that this interview has been edited for brevity and clarity.
Fed officials are finding services inflation to be a major concern. They have made it clear that they are looking for overall disinflation, but the slower inflation we have been seeing is mainly focused on goods and not so much on services. This is one of the main reasons why the Fed will be cutting rates later than expected this year. I have been anticipating around three rate cuts starting this summer, as we believed that inflation would be more persistent and the economy would be stronger. The main drivers of services inflation have been vehicle insurance, hospital insurance, and financial services. Two of these factors are structural, while one is temporary.
What does this mean for the Fed's challenge of determining the best time to start reducing interest rates?
The Fed is cautious about cutting interest rates too early to avoid losing credibility. They are closely monitoring the consumer and job market****s because while inflation remains steady, the economy continues to perform well despite higher rates and inflation. As long as the economy remains strong in the face of increased interest rates and inflation, there is no need for the Fed to rush into cutting rates. This approach reduces the risk of waiting too long and potentially causing a severe recession. The Fed is keeping an eye on both the possibility of broader disinflation beyond goods and any indications of economic slowdown.
Investors are now more optimistic about a soft landing, despite worries about inflation slowing down. Last year, many were anticipating a recession, but now the situation is different. However, if we receive more disappointing inflation reports, what could happen next?
The current market is more delicate compared to the beginning of 2023, mainly because valuations are high. Market prices are reflecting expectations of a smooth landing, particularly in the technology sector. If we receive more negative inflation data indicating a potential acceleration, investors may see it as a setback. This could lead to further delays in rate cuts, making it harder for the markets to maintain their current valuations.
Americans are currently facing the most severe housing affordability crisis in years. Baby Boomers are holding onto their homes, insurance costs are rising, mortgage rates are high, and many renters struggle to afford their monthly payments. As a result, some have lost hope of ever owning a home.
President Biden has stated that he has a plan to address America's housing affordability crisis. But the question remains: Will his plan be effective?
The issue has been developing for years and economists believe it is not a simple problem to solve. However, during Thursday's State of the Union address, President Joe Biden mentioned that the government has a solution in mind.
"I understand how crucial affordable housing is to you. As inflation decreases, mortgage rates will also decrease. Nonetheless, I am not going to wait," he stated.
Affordable housing advocates welcomed Biden's proposal to assist potential homebuyers in purchasing homes. However, critics argue that his plan may worsen the situation by increasing demand for homes without effectively tackling the root cause of the crisis: the lack of available homes in America.
On Thursday, Biden put forth a series of measures, such as new tax credits and legislation aimed at boosting home construction, to enhance housing affordability and expand the housing supply for both purchasing and renting.
Read more here.
Up Next
On Monday, we can expect to hear about the earnings from Oracle, Asana, and Vail Resorts.
Moving on to Tuesday, we will be looking out for the earnings reports from Kohl's and Guess. Additionally, the US Labor Department will be releasing its Consumer Price Index for February, and the US Treasury Department will be releasing its monthly budget statement for February.
Wednesday: Keep an eye out for earnings reports from Lennar, Dollar Tree, and Petco. Also, the UK’s Office for National Statistics will be sharing January data on gross domestic product and trade.
Thursday: Look out for earnings updates from Adobe, Dollar General, Ulta Beauty, Dick’s Sporting Goods, Getty Images, Build-A-Bear Workshop, and Zumiez. The US Labor Department will be releasing the Producer Price Index for February and the number of new jobless benefit applications for the week ending on March 9. Additionally, the US Commerce Department will be sharing February retail sales data and January business inventory figures.
On Friday, the US Labor Department will report export and import prices for February. The New York Fed will also release its Empire State Manufacturing Index for March. In addition, the Federal Reserve will release February figures on industrial production. Lastly, the University of Michigan will release its preliminary reading of consumer sentiment for March.
Editor's P/S:
The persistent inflation in the services sector poses a significant challenge for the Federal Reserve as it weighs interest rate decisions. Despite overall inflation showing signs of easing, the rising costs of essential services like healthcare, haircuts, and financial services remain stubbornly high. This trend is reflected in the Fed's preferred measure of inflation, the Personal Consumption Expenditures price index, which indicates that services prices stayed consistent at the beginning of the year.
The Fed's reluctance to cut interest rates too early is understandable given its commitment to bringing overall inflation down to its target of 2%. While the economy continues to perform well despite higher rates and inflation, the Fed is closely monitoring the situation. If services inflation remains elevated, the Fed may need to keep interest rates higher for longer to achieve its target. This could delay any potential rate cuts, which could have implications for the stock market and the broader economy.
