Thoughts

October 20, 2023 | 12:59

U.S. Inflation: Your Serve

Economist

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Chair Powell says inflation made further progress this summer, though the future “path is likely to be bumpy and take some time”. Evidence of this bumpy ride emerged from a large hiccup in the CPI proxy of ‘supercore’ inflation last month that could well show up in next week’s personal spending release. Excluding energy and rent, CPI services prices jumped the most in a year (0.6%) in September amid outsized gains in hospital costs, auto insurance and hotel rates. Meanwhile, rent is still clocking in at a monthly rate of around 0.5%, or over 6% annualized. With goods prices well behaved due to smoother-running supply chains and softer commodity prices (apart from oil), the onus is squarely on the services side of the court to set the duration of the Fed’s inflation grudge match.

Services inflation has made progress, with the CPI measure moderating from a cycle high of 7.6% y/y in January to 5.2% in September. But the latter compares with a modest 1.4% increase in goods prices in the past year and unchanged core goods prices. With services accounting for a hefty 62% slice of the consumer pie (almost half is rent), compared with 38% for goods, the wide chasm between the two doesn’t lend itself to a quick return to the 2% target. Even if goods inflation holds steady, services inflation would need to simmer down to a sub-3% pace to restore price stability, a downshift of more than 2 percentage points. (To be clear, the Fed targets PCE inflation and historically, CPI inflation tends to hover a few ticks higher.)

The broader the strength in services inflation, the rockier and slower the path to target. And unfortunately, the strength is still broad-based, though there are signs of cooling in some areas, notably travel-related.

In the ‘not-going-down-without-a-fight’ camp:

tenant and implied rents are still running above 7% y/y (and just under 6% on a 3-month annualized basis). A renewed increase in home prices isn’t helping.
auto insurance premiums are up a massive 18.9% with no sign of slowing.
auto repair costs have soared 10.2% with only modest signs of easing.
hospital services fees have picked up recently to 4.5%, while falling health insurance costs will reverse course in October, adding modestly to inflation in the year ahead.
recreation services inflation is still robust at 6.4% though moderating.
personal care services (e.g., haircuts) are up 4.8% while easing a bit, but miscellaneous personal services (e.g., legal) have accelerated to an 8.3% rate.

In the ‘we-got-this’ camp:

despite a sharp bounce last month, hotel rates are little changed since the spring, as are the costs of renting a vehicle, while airfares have plunged 13.4% in the past year to below pre-pandemic levels. The turnaround here likely reflects some satiation of travel demand as well as consumers pushing back against previous sharp increases.
tuition and daycare costs are subdued at 3.1% y/y.
communication service fees are flat in the past year.

Some recent loosening in labour markets and a moderation in wage gains are dampening services inflation. As well, business contacts in the Beige Book say they have “struggled to pass along cost pressures because consumers had grown more sensitive to prices.” Retailers are losing pricing power. These developments should help to slow overall inflation further.

Still, as Chair Powell warns, “We cannot yet know how long these lower readings will persist, or where inflation will settle over coming quarters.” One thing is clear: the inflation outlook will depend on how soon the economy decelerates from the estimated 5% growth last quarter to a sub-potential rate of under 2%. Without a sharp slowing in growth, the Fed can’t declare ‘game, set, match’.