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Where’s the disinflation in services?
In his press conference on Wednesday, Federal Reserve chair Jay Powell said that “disinflation appears to be continuing for services”. Unhedged doesn’t think it is.
Using one reasonable cut of the data, services inflation is about a percentage point above the Fed’s 2 per cent target, and its most recent trend is up. Here is PCE services excluding energy and housing services, or “supercore services”:
There is something of a downward trend in the six-month moving average, but the swing upward in the past three months tells a different story.
One might object that it is unfair to exclude housing prices, which have been the lead villain in the Fed’s fight against inflation and are finally falling. So let’s have a look at the two components of housing, rent and owner’s equivalent, or imputed, rent:
Rent (dark blue line) is hovering around its average from the five years before the pandemic (the pink line). Imputed rent (light blue) had been at its pandemic level before a recent bounce. Housing is not a major disinflationary force that the supercore misses.
We asked our favourite expert on the details of inflation, Omair Sharif of Inflation Insights, if he sees any services disinflation. He wrote:
I do not. Core services inflation and the supercore have both firmed in the last two reports, right on cue. This is largely a story about airfares and hotel rates recovering in the CPI . . . we’ve still got some more of that in the pipeline for the second half. Plus, we had a soft medical care services print in August that is unlikely to repeat. So, the supercore services index will probably continue to firm into the second half. I was a bit surprised [Powell] was so sanguine about that given the recent rebound.
Nor should we be reassured by the fact that service prices are only rising in certain categories. Wage growth, which had been accelerating, has been parked above 4 per cent — well above its long-term trend — all year.
It’s great to see strong wage growth, but this is consistent with services inflation staying high.
How much should we worry about this? I’m not sure. The Federal Open Market Committee appears ready to tolerate a little heat in the economy. Its just-released summary of economic projections foresees a 2.6 per cent inflation rate at the end of 2026, which is about where it will be if tariff-driven goods inflation dissipates and services inflation remains at about 3 per cent. The concern, however, is not that services stays at 3 per cent for a while; that would be tolerable. The worry is that the absence of services disinflation reflects an economy that is running a bit above potential already, and that rate cuts might cause price increases to accelerate.
(Armstrong)
Waiting on the end of quantitative tightening
Wednesday’s Federal Reserve meeting gave investors the rate cut they wanted, but withheld another treat: the end of quantitative tightening, the central bank’s balance-sheet reduction programme.
When the Fed, under QT, gradually allows the Treasuries on its balance sheet to mature and then cancels their principal, it pulls liquidity out of the financial system. This could, in theory, lead to higher interest rates, lower asset prices and lower economic growth, or cause a liquidity crunch in the style of 2019 — all of which investors would be happy to do without.
In March, the Fed announced that it would be slowing QT from a monthly run-off of $25bn to about $5bn. Investors took that as a sign that QT would end sometime in the second half, probably around September. So the persistence of the programme is a bit of a surprise. The Treasury has been rebuilding its general account at the Fed, which also pulls liquidity out of the system. And, as a reporter noted to Powell on Wednesday, it’s odd to cut rates, which boosts liquidity, while continuing QT, which does the opposite. Powell replied that:
We are cutting the size of our balance sheet quite marginally now . . . We are still in abundant reserves condition, and we said we would stop somewhere above an ample reserves level . . . We don’t think that has significant macroeconomic effects.
So far, QT has not had a noticeable impact on the market or growth. The upward pressure on Treasury yields has been minimal, and there hasn’t been a liquidity crunch. And, as Brij Khurana at Wellington Management argued to Unhedged, the tension between rate cuts and QT is overplayed. “After the GFC, the market started viewing QE and rate policy as connected, because QE is a means of boosting [economic activity] when rates are down to zero . . . but really [they] are different decisions,” he said. QT is less about rates than about overall liquidity.
And, as Powell suggested, we are not quite to the target level of liquidity. The standard measure of liquidity takes the sum of bank reserves held at the Fed and the balance in its Reverse Repo Facility (another liquidity regulation tool) as a percentage of GDP. In 2019, the repo crisis kicked off when that measure was about 7 per cent of GDP, so the Fed aims to end QT somewhere above that threshold. The RRP funds are mostly tapped out and bank reserves held at the central bank have been coming down, but the sum is about 11 per cent of GDP, leaving QT with some room to run:
The rebuild of the Treasury General Account is not adding much pressure, either. As Tom Simons of Jefferies noted to us, while rebuilding the Treasury’s coffers by selling more Treasuries pulls cash out of the system, what matters is how that money is spent. Donald Trump’s budget, controversially, pulls forward spending, and delays budget cuts. The money pulled into the TGA will be back in the financial system before long.
That QT has and is continuing without creating problems, even as the economy falters a bit, tells us two things. First, QT works: it is possible to gradually reverse QE without reversing the benefits of QE or breaking the financial plumbing. Second, financial conditions in the US economy are not particularly tight, despite concerns over the labour market. That’s a data point both the Fed and investors might want to consider.
(Reiter)
One good read
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