November 17, 2023 | 13:32
Services Inflation: Broadly Speaking
Services Inflation: Broadly Speaking
“We cannot yet know… where inflation will settle over coming quarters.”—Fed Chair Powell, October 19, 2023
“The effects of higher interest rates on inflation are most evident in the prices of durable goods… as well as many services excluding shelter.”—Bank of Canada Governor Macklem, November 1, 2023
With goods prices calmed by smoother-running supply chains and lower resource prices, the burden is now squarely on the shoulders of services inflation to fall in line. However, if costs are still running hot across a wide range of services, then restoring price stability will take longer. The breadth of services inflation could determine whether central banks will need to raise rates further and whether the economy will land with a thud or gently.
A robust U.S. economy is keeping inflation’s feet to the fire, at least on the services side. Though down from a cycle high of 7.6% y⁄y at the start of the year, CPI services prices are still up a steamy 5.1% y/y in October and shorter-term trends suggest the earlier deceleration is losing momentum. This compares with almost no change in goods prices in the past year (Chart 1). Even if goods prices hold flat, services inflation (which accounts for a hefty 62% share of the consumer basket) would need to slow by nearly two percentage points to bring overall inflation back to the 2% target. Favourable year-ago comparisons will help, but the monthly increases will need to ease from the current 5.3% three-month annualized rate.
Recent moves in U.S. services inflation can be grouped into two broad camps.
High and sticky:
Low or improving:
U.S. services inflation is moderating, but the still-large number of sticky areas—accounting for more than half of the services basket—suggests future progress will be slow. This is supported by recent trends in ‘supercore’ prices, which excludes energy and rents. This metric has decelerated from a cycle-high 6.5% y⁄y to a two-year low of 3.7%, though shorter-term trends suggest a firmer underlying rate of around 4% (Chart 2, again).
The still-broad strength in services inflation could reflect a pickup in real services spending to 3.6% annualized in Q3. While a slower yearly rate (2.4%) implies a less robust underlying pace, even that doesn’t point to a rapid easing in price pressures. However, with services demand now largely back to pre-pandemic trends and excess savings of many lower income families thought to be mostly depleted, some cooling should be expected, as suggested by a soft October ISM survey.
Slower services demand should reinforce other trends that are acting to cool inflation in the sector. The pullback in travel-related prices likely reflects satiated demand. Some moderation in wage growth may be lowering the temperature on services prices, as employment cost growth among service-providing industries has eased from a cycle-high 5.2% y⁄y to 4.5% in Q3. Notably, wages are slowing in leisure and hospitality, which previously struggled to restaff during the pandemic. Also helping to relieve services inflation is ebbing pricing power, with contacts in the Fed’s Beige Book claiming they have “struggled to pass along cost pressures because consumers had grown more sensitive to prices”.
With U.S. services inflation likely to see a relatively slow trek back toward price stability, we now turn our attention to the situation in Canada.
In Canada, everything seems to hinge on the housing market. Shelter costs rose faster than in the U.S. during the pandemic and have yet to see much cooling. Although existing home prices were under intense pressure in 2022, new home prices—which feed into the CPI—have eased only slightly. Higher interest rates, though taking some steam out of the market, have also boosted mortgage interest costs in the CPI. Shorter mortgage duration leads to faster pass-through than in the U.S. This means that a 31% y⁄y spike in mortgage interest costs is now the leading driver of inflation in Canada. Meantime, softer home prices haven’t curbed rents, as investors try to recoup rising credit costs and as torrid population growth fans demand. So, there’s little relief from shelter costs whether you rent or own a home (Chart 6).
In contrast, a Canadian CPI equivalent to the ‘supercore’ measure suggests non-housing core services prices are cooling rapidly. As of September, the 1.5% y/y rate was below the 2% mark for the first time since January 2022 and more than two percentage points below the U.S. counterpart. It’s also much less than overall services inflation, which, at 3.9% y⁄y, is down from a peak of 5.8%. This points to widespread services inflation at or below the target outside of housing.
But there are differences between sectors. Chart 7 shows travel-related prices, a poster child for the spike in services demand after pandemic restrictions were lifted. After jumping in late 2021, growth in airfares and hotel prices peaked the following summer before cooling its jets. Now, airfares are down over 20% from year-ago levels, though accommodation costs are still up 10%. The divergence could reflect a shift towards trips that are closer to home, such as weekend getaways or staycations that don’t require air travel.
Still, there are pockets of persistence. Take restaurant food as an example where prices have slowed only modestly and are still up 6.1% y⁄y in September (Chart 8). Also hard to swallow is that prices of served alcoholic beverages are up 6.4% y⁄y, and look to be gaining momentum.
It appears that demand for some services persists, despite the broader slowdown in the economy. While growth in real services consumption eased to 2.1% y⁄y in Q2 from a double-digit rate last year, some usual suspects are rising at a stronger pace. Spending at restaurants and bars rose 2.8% y⁄y, while accommodations jumped 4.0% and air transportation a whopping 37% (though it is still below pre-pandemic levels). The Q3 GDP release at the end of November will provide timelier data and is expected to show a further slowing in line with easing price pressures.
Bottom Line: A stronger economy with tighter labour markets and firmer services demand likely explains the higher and more pervasive services inflation in the U.S. than Canada. U.S. households are spending roughly 5% less income on debt payments than Canadian families, leaving more room to spend on services. This could explain why non-housing services inflation has fallen below target in Canada, while the U.S. still has a way to go. But it remains to be seen whether recent progress will be sustained, so we don’t expect the Bank of Canada to reduce rates anytime soon. That goes even more so for the Fed.
The Fed targets the rate of change in the personal consumption expenditures price index rather than the CPI. On this basis, services prices were up 4.7% y⁄y in September versus 5.2% for the CPI equivalent that month. PCE services inflation tends to run several tenths below the latter partly due to substitution effects that favour cheaper services.