Service sector inflation looks sticky

March 12, 2024

The consumer price index (CPI) rose 0.4% in February, a slight acceleration over the 0.3% increase logged in January. That jump was buoyed by an increase in energy prices and persistently strong shelter inflation. The increases in those two components alone accounted for more than 60% of the acceleration in inflation in February. The Bureau of Labor Statistics has altered the composition of homes in its rent equivalent index which boosted shelter inflation last month; this month shelter costs decelerated from the pace we saw in January. Rents and owners' equivalent rents better aligned. The overall index moved up from 3.2% from a year ago, up slightly from last month's pace of 3.1% last month.

The core CPI, which excludes food and energy, also rose 0.4% in February, the same as January. The core CPI was up 3.8% from a year ago in February versus 3.9% in January. Prices of big-ticket items like new vehicles, major appliances and furniture were all down, while prices in the service sector picked up. Used vehicle prices partially reversed a large drop in January. The lingering inflation in the service sector is what is worrisome to the Federal Reserve.

The supercore services measure, which excludes shelter and energy costs, rose 0.5% in February, up from 0.9% rounded in January. The super core has moved up to a 4.4% increase from a year ago in both January and February and from 3.9% in December. The three-month and six-month annualized figures for service sector inflation have also moved up. That is not welcome news, as the service sector dominates the economy and services inflation may be getting sticky.

Medical services moved up along with insurance costs (home, renters and vehicle). Airfares and hotel rates moved up as well but remain subdued relative to a year ago. The number of those out on vacation in the month of February was still extremely elevated. TSA throughput has blown through 2019 levels. Leisure travel continues to do better than business travel, but there has been a rise in those who travel for leisure to pay up for first class seats.

Moreover, the components of the CPI that are now rising at more than a 4% annualized rate have increased in recent months. That suggests that the service sector inflation we are seeing is becoming more dispersed.

The Fed is hopeful in achieving a soft landing. That includes a modest rise in unemployment. The challenge is to enable only a modest increase. The unemployment rate has moved off the cyclical low of 3.4% in April 2023 to 3.9% in February 2024. It is starting to flirt with the Sahm Rule, which is an early indicator that a recession is underway. The Fed has made clear that a modest rise in unemployment, even if it breaches that threshold, would be considered a "soft landing." The challenge for the Fed is that unemployment tends to rise in a nonlinear way; once it starts to move up, it tends to move up rapidly. The latter scenario is something the Fed would like to avoid.