MNI INTERVIEW: Fed Focus On Service Prices In Tough Last Mile

Federal Reserve policymakers will be squarely focused on core services prices and wage growth next year in counting progress on the toughest last mile in fighting inflation, but labor market and financial stability concerns will likely start to take precedence in the debate over when to start cutting interest rates, St. Louis Fed economist Michael McCracken told MNI.

As encouraging as this year's faster-than-expected progress on inflation has been, the cost of rent, auto insurance and recreational services among others have been slow to calm, McCracken said. Shelter inflation has accounted for about half of the 4% increase in core CPI over the past year. Core services overall rose at an 4.1% annualized rate in October, while “supercore” services prices, which exclude shelter costs, increased at an annualized 4.5% last month and are up 3.9% over the past six months.

"If we can get housing down a bit next year, I imagine inflation expectations will tick down a bit. That, along with reduced wage growth -- which goes hand in hand with core services -- will get us that extra mile to get us below 3%," McCracken said in an interview. "But I start to worry about that last mile getting dragged out if the labor market weakens." (See MNI INTERVIEW: Robust Wages Will Keep Inflation Elevated-ADP)

EXCESS SAVINGS SHRINKING

The October CPI report was remarkable in that there was no surprise outlier number in any category that kept the inflation rate moving sideways instead of decelerating, McCracken said. Headline CPI was nearly unchanged compared to September, while core CPI also came in a tenth below analyst expectations.

Softer-than-expected PPI and retail sales reports then followed, "hedging against this month's being a headfake," he added.

That said, McCracken does not view the stronger-than-expected September and August CPI reports as departures from the underlying trend either.

"I’m a big fan of the excess savings story," he said, referring to the extra trillion dollars or so American households amassed during the pandemic. "The September pop in lodging scared me because it means people have discretionary money for traveling. Now we finally see lodging and airfares come back down. That's what I want to see -- discretionary spending declining. People are probably doing that because they're less comfortable with what's in their back pocket."

STUCK IN THE UPPER 2S?

With excess savings running down and red-hot demand for restaurants and airfare cooling, supercore services prices are poised to head in the right direction, McCracken said. Newly-signed leases foreshadow rent inflation fading over the coming months, but a lack of inventory has seen supply shrink even faster than demand, he said.

Policymakers will face a true dilemma on the policy path when unemployment ticks up to just above 4% and inflation is in the upper-2s, McCracken said.

"I'm inclined to think rate cuts will be more in line with employment than inflation," he said. If the pace of hiring falls under 100,000 a month and inflation is below 3%, "I can imagine the hawks on the committee saying, you might not make me vote to raise rates but I won’t cut them, because our job is to get inflation to 2%, on average."

Financial stability considerations will also rise in importance, he said. "The regional bank stress made everybody want to take a breath. The commercial real estate market will make people think maybe that’s another reason to take a breath," he said. "Employment will have to really start to do badly for a true discussion on cuts to occur."