Will Service Sector Prices Prevent the Federal Reserve from Reaching Its Inflation Target?
Former JPMorgan Chase Global Chief Economist, (Ph.D, Economics) & Current BrightQuery Chief Economist
In a recent client presentation, I was asked how U.S. inflation could decline from current levels if U.S. service prices remain stubbornly high. The Consumer Price Index (CPI), excluding energy services, was used to make this argument. In October 2023, it rose at a yearly growth pace of +5.5%, well above the Fed’s 2.0% inflation target, albeit lower than its +7.3% February 2023 peak! The importance of the service sector cannot be overstated, given that it comprises 61.8% of the CPI, while the goods sector accounts for the remaining 38.2%.
Many have also argued that service prices are sticky and unlikely to decline even if the Fed succeeds in slowing economic activity or if the economy slips into a recession. However, history does not support this pessimistic view. The shaded areas represent U.S. recessions, and we can see that following 1969-70, 1973-75, 1980, 1981, 1990 -91, 2001, 2007-09, and 2020 recessions, U.S. service prices moved lower during the downturn or shortly afterward.
Tracking the Gold Standard Inflation Metric
Despite the popularity of the CPI, it is no secret that the Federal Reserve considers the Personal Consumption Deflator (PCE), and some components of this index as the Gold Standard of inflation metrics. This index weights the consumption components based on real-time consumer expenditure patterns. While this metric exceeds the Fed’s 2.0% inflation target, it has moved lower recently. The headline figure is now rising at a 3.0% yearly growth pace, while the core measure, which excludes food and energy, is down to 3.5%. Those increases represented the smallest gains since March 2021 and April 2021, respectively!
The inflation measure favored by Fed Chair Powell is the Super-Core Services inflation rate, which measures PCE service inflation, excluding energy and housing services. That metric rose at a 3.9% yearly pace in October 2023, down from a peak of 5.2% in December 2021 and 4.3% last month.
But Why Not Measure All CPI Service Prices?
If our goal is to blame service prices as the reason inflation is unlikely to reach the Fed’s 2.0% inflation target, why not look at all service prices instead of cherry-picking a select group of such costs? When we conducted this inquiry, we found that all CPI service prices had fallen from a peak of +7.6% in Feb. 2023 to +5.1% in October 2023.
Can We Predict Service Prices?
For all of you who are wondering if a leading indicator of U.S. service prices exists, you are in luck. The Producer Price Index publishes a monthly measure of final services prices that measures what companies pay to provide such services to consumers. This metric captures the costs companies bear when providing such services to consumers and has plunged from a +9.4% yearly rise in March 2022 to a +2.6% in October 2023. Companies usually pass these costs onto consumers with a lag and are currently hinting that service prices should continue to drift lower!
What Other Developments Are Signaling Lower Inflation?
Federal Reserve Chair Jerome Powell has repeatedly said that slowing U.S. economic growth is an excellent way to lower inflation. In Q3 2023, the U.S. economy grew at an inflation-adjusted pace of +5.2%, but in Q4 2023, growth is projected to slow to a mere +1.2% by the widely respected Atlanta Fed-nowcast model. This growth deceleration couldn’t come at a better time when inflation has begun to ease.
Additionally, despite the smaller size of the goods sector, whose components account for 38.2% of the CPI, Durable Goods PCE prices have collapsed from a yearly growth pace of +10.7% in Feb. 2022 to a -2.3% annual growth pace in October 2023!
Summary and Concluding Thoughts
The view that service prices will prevent the Federal Reserve from achieving its inflation target is somewhat misguided. Instead, it is more likely that the path of service prices will determine how long it takes to reach the Fed’s goal of 2.0% inflation. With service prices moving lower and some goods prices experiencing outright deflation, we view the attainment of the Fed’s inflation target as inevitable over the next 12 to 18 months. However, if the U.S. were to enter a recession and experience a collapse in economic activity, we could envision the Fed hitting its inflation target sooner or within the next 12 months!