Sticky inflation in a key part of the U.S. economy is the biggest barrier to Fed rate cuts

The Federal Reserve is winning the battle against high inflation, but the fight is not over yet, a parade of senior bank officials told Wall Street this week.

Why the stern lecture? Fed insiders appear to have been taken by surprise by a big market rally after the central bank left a key short-term interest rate unchanged last week. Stocks jumped to a record high and long-term rates fell sharply.

Giddy investors viewed the Fed decision and encouraging words from its chair, Jerome Powell, as a sign the central bank would begin to cut interest rates starting in March as inflation continued to slow.

Fed officials, on the other hand, insist it’s premature to declare victory or to begin to plot the first rate cut.

The reason: Inflation has proven to be sticky in major parts of the economy. There’s a lingering worry at the Fed that it might not slow as quickly as Wall Street expects.

The biggest area of concern is the cost of services, which has not slowed as much as the price of goods such as furniture, appliances and consumer electronics.

The cost of goods excluding food and energy was actually flat or unchanged in the 12 months ending November 2023.

That’s a big sign of relief after the annual increase in the cost of goods surged to a 40-year high of 12.3% in early 2022. It also explains the big deceleration in inflation over the past year.

Part of the slowdown in the cost of goods stems from a shift in consumer spending habits.

Americans bought a lot of goods during the pandemic when they were cooped up at home. After the pandemic ended, they bought relatively fewer goods. Instead, they went out a lot more and spent heavily on services such as dining out, travel, recreation and entertainment.

The record demand for services pushed businesses to hire rapidly, but they had to pay more to attract workers amid the biggest labor-market shortage since World War II. So businesses charged customers more in order to offset higher costs for materials and labor.

As a result, service inflation has been much stickier than goods inflation, especially since last summer.

The yearly rate of so-called supercore inflation, which excludes goods, energy and rent, tapered to a two-year low of 3.6% in September from a peak of 6.6%. But it has actually bounced back up to 4% in the past two months.

“Goods have [continued to] come down. Services have not,” said Tom Barkin, president of the Richmond Federal Reserve.

The biggest culprits have been recreation and transportation.

The cost of car insurance has soared 19% in the past year, for instance, while car repairs cost almost 13% more than they did a year earlier, the consumer-price index shows.

The cost of recreation, including cable and streaming TV, is up almost 5% compared with a year earlier.

“These data indicate still firm inflationary pressures on the services side of the economy,” economists at Nationwide Economics wrote in a note to clients.

Service prices are even higher if rent and housing — the single biggest expense for most families — are taken into account.

The Fed is banking on shelter costs decelerating sharply in the months ahead. A quirk in how the CPI estimates shelter costs results in long lags before price changes show up in the data. That’s why the Fed has put more emphasis lately on the supercore number.

If the cost of shelter doesn’t slow as much as expected, however, it could keep inflation elevated. Overall inflation is still rising 3% a year, above the Fed’s long-term goal of 2%.

Another potential wild card is rising medical costs, the second-biggest expense for many families, which could also delay the return to 2% inflation.

Some analysts contend hiring has to slow and unemployment must rise to ensure that inflation glides down to the Fed’s target. Labor costs are still too high, they say.

“Services prices broadly are unlikely to continue slowing back towards 2% until the labor market loosens further,” economists Andrew Hollenhorst and Veronica Clark of Citi said in a note.

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