Services Prices Should Cool in Time, Too

Tuesday was that rare day this time of year: a day when investors had all manner of interesting things to parse in the financial headlines. We had the fine folks at Lawrence Livermore Labs in Berkeley announcing a nuclear fusion breakthrough. The arrest of FTX founder and ex-CEO Sam Bankman-Fried for fraud and conspiracy just hours before he was set to testify to the House Financial Services Committee. The leaking of his prepared remarks, which, yowza. The testimony of his successor and FTX’s conservator, John J. Ray, before the same committee, and the occasional entertainment in some lawmakers’ questions.^[i] The Bank of England’s announcement that it is going to try stress-testing the shadow banking sector, including hedge funds and private equity lenders, in hopes of reining in non-bank financial institutions. Any and all of these may merit exploration, but Tuesday also saw the release of US November Consumer Price Index (CPI) data, which hogged all the attention. In focus this time: the divide between falling goods prices and rising services prices, which spurred questions about how much more the Fed will have to hike to curb wage growth in the sector. We see some interesting nuggets here, as we will discuss, but the related Fed speculation is a bridge too far.

Overall, November’s CPI report pointed to continued improvement. Headline CPI slowed from 7.7% y/y in October to 7.1%, 2 percentage points down from June’s high.^[ii] Core CPI, which excludes food and energy prices—stripping out the immediate effect of falling oil and gas prices—eased from 6.3% y/y to 6.1%.^[iii] On a month-over-month basis, CPI rose just 0.1% from October, while core CPI rose 0.2%, both below their long-term averages.^[iv] Looking deeper under the hood, core goods prices actually fell -0.5% m/m, but core services rose 0.4%, and those increases were broad-based among services industries.^[v] Hence, concerns about “stickier” services prices keeping inflation high, if not reaccelerating, as companies pass higher labor costs on to consumers, potentially forcing more big rate hikes in early 2023.

We guess we can see why this fear has legs. Even when you strip out shelter prices, which are a major component of services—and which should ease as falling home prices feed into rents—services prices weren’t pretty. Recreation prices rose 1.0% m/m.^[vi] Personal services prices rose 0.8%. The “food away from home” category rose 0.5%, driving concerns about the restaurant worker shortage pushing up prices.^[vii] The main detractor from services prices, medical care services’ -0.7% month-over-month drop, reflects corporate accounting, not actual prices.^[viii] It all feeds into the presumption that demand for services workers is too high, forcing the Fed to throw yet more cold water on the economy.

In our view, that doesn’t quite wash. For one, service sector wage growth peaked nearly a year ago. Leisure and hospitality employees’ average hourly earnings grew 13.3% y/y last December versus just 6.4% in November 2022.^[ix] Professional and business services workers’ hourly earnings have slowed from 7.0% y/y in March to 5.4% in November.[x] Both slowdowns predate Fed rate hikes—and most research shows Fed moves take anywhere from 6 to 18 months to affect the economy. So that slowing likely isn’t about Fed hikes—it seems much more about pandemic-related dislocations slowly evening out. (Exhibit 1) It is taking longer in services than in physical goods since the production sector didn’t lock down to the extent most services did. But just as pandemic hiccups in the “stuff” economy have faded, so should the speedbumps in services.

Exhibit 1: Services Wages Are Moving Past Lockdown Weirdness

Source: St. Louis Fed, as of 12/13/2022. Year-over-year percent change in average hourly earnings of leisure & hospitality employees and professional & business services employees, January 2019 – November 2022.

Then again, this is all probably secondary to consumer services prices, as the wage-price spiral is as mythical in services as it is in goods. One easy way to see this? Put yourself in the shoes of a self-employed hair stylist. This year, you will have shouldered all manner of rising costs. You probably pay more to rent salon space. If the salon owner apportions power and water costs among you and your fellow stylists, those costs have gone up. You are paying more for styling products and hair dye. So you have two choices: You can keep charging your clients what they paid last year, which effectively means you swallow a pay cut as your living costs rise. Or you can raise prices and hope your clients will stick around so that you can continue eking out a living. Chances are you will raise prices.

Said differently, labor is but one cost that services firms must factor in when setting prices. Other costs include energy, water, telecommunications, building maintenance, property, janitorial services, office supplies and equipment. Restaurants must add in food costs. The vast majority of these costs are far downstream from commodity prices, which have been filtering their way through CPI all year. They showed up first in goods prices, particularly those categories with petrochemical feedstocks (e.g., anything with plastic and synthetic rubbers). Services are simply a few links further down the supply chain, so they felt the effect at more of a delay, hence why services inflation has lagged goods inflation. (Exhibit 2) But just as spiking commodity prices are busy working through the goods side of the economy, so should they soon work their way through services.

Exhibit 2: Core Goods and Services Prices

Source: St. Louis Fed, as of 12/13/2022. Year-over-year percent change in commodities less food & energy commodities prices and services less energy services prices, January 2019 – November 2022.

Note, none of this means we subscribe to the theory of “cost-push inflation.” Inflation is inflation, and it all stems from too much money chasing too few goods and services. We are simply suggesting that, on this occasion, those basic inflationary forces affected goods prices first, then filtered through to the rest of the economy. That isn’t unusual, given our economy’s breadth, depth, complexity and decentralization. It also means there is little for the Fed to do at this point, considering disinflationary forces are already in place and the supply shortages (real and feared) that pushed prices high earlier this year have eased. We can see that in goods prices as well as raw commodity and energy prices, falling transit costs and broad money supply growth’s severe slowdown. Market-based inflation indicators are registering this, down nicely from mid-year highs. (Exhibit 3)

Exhibit 3: 5- and 10-Year Breakeven Inflation Rates

Source: St. Louis Fed, as of 12/13/2022.

That said, Fed moves are unpredictable, so who knows what those folks will announce tomorrow or at subsequent meetings. But whatever they do or don’t do, it probably means precious little for inflation.