Regulation and Delayed Updates: Why Services Inflation Will Likely Stay High

Apart from some possible geopolitical upset (and theater with the debt ceiling), the Big Issue for the larger economy, and for investing decisions, remains how fast inflation will decline – since that governs how soon the Fed can relent on keeping interest rates high. Those high interest rates are having all kinds of knock-on effects, including bank failures and suppressed home sales.

The investing market seems to be pricing in expectations of significant Fed rate cuts before the end of 2023, which in turn presupposes that inflation will have ratcheted downwards far enough by then to allow the Fed to declare victory. Goods inflation (= mainly stuff made in China) has declined nicely, but services (which comprise the majority of household spending) remains high. It is coming down, but too slowly to realistically hit the Fed’s 2% target this year.

In an article in the Seeking Alpha site title Services Inflation Is Stuck, the investment firm Blackrock notes some technical factors that will likely keep services inflation high for at least the remainder of this year. I will paste in their text in italics:

Core Services ex-Shelter inflation is a bit of a hodgepodge that includes things like medical care services, video and audio services, tuition, and insurance. It comprises roughly a quarter of the CPI basket and, importantly for the Fed, is very domestically oriented.

A key insight from this article is that nearly two-thirds of this key “Core Services ex-Shelter” component consists of:

(1) Service prices that are regulated (especially insurance), and

(2) Services with infrequent price resets (such as tuition and especially medical services):

There are technical factors that make it likely that these particular items will see ongoing, sticky inflation:

Impact of Regulated Prices

Regulated prices tend to be more discrete and more lagged in their changes due to bureaucratic delays and their negotiated nature. Some types of regulated prices, like postage or water and sewage fees, are easily recognizable as subject to government regulation. Somewhat less intuitive is the degree to which insurance in the United States is a regulated price. Insurance comprises the largest share of Core Services ex-Shelter basket and state-level insurance commissioners play important roles in negotiating auto, property, and casualty insurance price changes.

The underwriting costs of insurance have been surging globally – a combination of higher reinsurance premiums, inflated asset values, and more natural disasters. These rising costs have only just begun to flow through into consumer prices; auto insurance costs were an upside surprise within March’s CPI report.

Jumps in Medical and Education Prices Will Appear Later

Though the market has been fixated on the painstaking details of the month-over-month inflation prints, many of the sub-components of the CPI do not update monthly. Two of the more important items within the core services basket – medical care services and tuition – only update their prices annually. Coincidentally, updates for both of these categories take place in the autumn, and both are set to rise strongly.

Medical care services are the largest component (28%) of Core Services ex-Shelter, but have a complex and lagged computation and update only once a year in October. Medical services inflation has been negative since last October as a consequence of excess consumer demand for post-pandemic doctors’ visits, however, we expect this mechanical effect will abate later this year and thereafter lift core services inflation.

Tuition is another example of a service with intermittent price resets, given prices are set on the basis of the academic year. We expect the broad-based upward wage pressure in education to be passed through to higher education consumer prices later this year when students return to school.

And so…I expect “higher for longer” inflation and interest rates.

It’s Still Hard to Find Good Help These Days

Consumption is the largest component of GDP. In 2019, it composed 67.5% of all spending in the US. During the Covid-19 recession, real consumption fell about 18% and took just over a year to recover. But consumption of services, composing 69% of consumption spending, hadn’t recovered almost two years after the 2020 pre-recession peak.  For those keeping up with the math, service consumption composed 46.5% of the economic spending in 2019.

We can decompose service consumption even further. The table below illustrates the breakdown of service consumption expenditures in 2019.

I argued in my previous post that the Covid-19 pandemic was primarily a demand shock insofar as consumption was concerned, though potential output for services may have fallen somewhat. When something is 67.5% of the economy, ‘somewhat’ can be a big deal. So, below I breakdown services into its components to identify which experienced supply or demand shocks. Macroeconomists often get accused of over-reliance on aggregates and I’ll be a monkey’s uncle if I succumb to the trope (I might, in fact be a monkey’s uncle).

Before I start again with the graphs, what should we expect? Let’s consider that the recession was a pandemic recession. We should expect that services which could be provided remotely to experience an initial negative demand shock and to have recovered quickly. We should expect close-proximity services to experience a negative demand and supply shock due to the symmetrical risk of contagion. Finally, we should expect that services with elastic demand to experience the largest demand shocks (If you want additional details for what the above service categories describe, then you can find out more here, pg. 18).

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