MNI: Services Inflation Seen As The Fed's Next Big Problem

Inflation in the vast U.S. service sector may soon replace the surge in goods prices as the Federal Reserve’s primary headache as wage increases gain traction, Mickey Levy, and an advisor to the Treasury’s Office of Financial Research, told MNI.

“Even when we get through these bottlenecks in production and goods prices come down – that will be more than offset by the services and you’re going to be stuck with high inflation, said Levy, who also advises several Fed banks, together with the Bank of Japan and the European Commission, and is chief economist for Asia and the U.S. at Berenberg Capital.

“The probability that inflation stays high, say over 4% in 2022, is a higher probability than that it comes back toward where the Fed thinks it will,” he said.

Levy says his own analysis of inflation trends suggests the services component of the Fed’s preferred PCE price index is set to jump from just over 4% late last year to 5% or higher – and then stay there for the foreseeable future.

“We forecast that OER is going to accelerate here to at a minimum 5% and then stay there through the middle of 2023,” he said, referring to the owner’s equivalent rent measure from which housing inflation measures are computed.

Those figures might actually underestimate the extent of recent gains given a Zillow rental cost index that is up 15% over the last year alone, Levy added.

“We find a very close correlation between OER and the PCE price index for services, with about a six month lag.

Levy said the wide range of industries included in the services sector was more highly sensitive to wage increases than goods production.

“Many of the industries, like leisure and hospitality and the like tend to be very labor intensive. And wages are going to catch up to inflation,” he said.

FED FORECASTS TOO ROSY

In that light, Levy said, the Fed’s December forecasts for core PCE to end 2022 at 2.7% and 2023 at 2.3% look unrealistic.

“There’s no way you come down that low for 2022 with what I see with my estimates on services. This is not just my guess, this is based on empirical work,” he said.

Consumer prices soared far beyond Fed officials’ and market expectations over the course of 2021, surging 6.8% in the year to November. The Fed’s preferred PCE measure jumped 5.7% over the same period.

The central bank last month pivoted toward acknowledging the spike was not just “transitory” but rather persistent enough to warrant at least three rate increases this year, with another three in 2023.

But Levy argues that, with inflation high and likely to remain so, that still leaves monetary policy far too loose.

“They’re saying the most appropriate monetary policy is to keep the real funds rate negative,” Levy said. “To me that not only fails to bring inflation down, it doesn’t even get the funds rate back to neutral.”

Levy was earlier than most in warning of the inflation risk of very active fiscal and monetary stimulus policies – he penned an op-ed entitled "The Short March Back to Inflation” last February.

His findings confirm what the ISM survey chair told MNI Thursday following a rise in the service sector's prices paid index to the third highest level ever.