“We have been missing our mandate on the inflation side, our objective of 2%, for more than four-and-a-half years, and I continue to see that we have pressure in inflation both in the headline, in the core, and particularly, where I am worried about it, is I’m seeing it in the services”
—Cleveland Federal Reserve President Beth Hammack
This is an underreported and underappreciated aspect of the Fed’s inflation dilemma. The Fed’s monetary policy can — at least in theory — be effective in managing demand-pull inflation. Higher interest rates dampen demand, which reduces inflation. Whether the Fed wields this power effectively is another story. But it’s within their power. They can control demand-pull inflation if they choose to.
But there’s really not much the Fed can do about cost-push inflation.
Cost-push inflation is what you get from a supply shock. The oil embargoes of the 1970s are a good example. OPEC cut off the supply of crude oil, which caused fuel prices to surge and pushed inflation throughout the supply chain. The 2020-2021 pandemic-era supply-chain snarls were another good example. The effects of the Trump tariffs have still been pretty minimal. But any inflation we get from the tariffs would be yet another example of cost-push inflation.
But what about about the inflation in services that Hammack is so concerned about?
Inflation in services is still coming in hot, rising at 3.6% per year. That’s well below the post-pandemic peak. But it’s still stubbornly high… and it’s been stuck at that level since March.
So, what’s the story?
We can’t blame services inflation on the tariffs, as tariffs are taxes on imported goods only.
Services inflation is tied to the labor shortage. Services are labor intensive. And a shortage of affordable labor makes it more expensive to provide services.
The immigration crackdown is a factor, of course. An estimated two million immigrants have been deported or have voluntarily left the country this year. Reducing the labor supply by two million people makes labor more expensive, all else equal.
But the bigger story is demographic.
The working age population in the United States enjoyed massive growth throughout the 1970s through the mid-2000s. As birthrates slowed in the 1970s and 80s, working age population growth started to slow on a 15-20-year lag. The babies not born in 1985 wouldn’t be joining the labor force in the early 2000s.
Between 2006 and 2016, growth slowed to a crawl. And then it flatlined for about five years before starting to climb slightly in recent years.
Based on the exceptionally low birthrates that have prevailed since 2008, we know that growth in the working age population won’t be picking up any time soon. Minus a massive surge in immigration — which is very clearly not going to happen any time soon — we can expect a tight labor market for the foreseeable future. (A recession would alleviate this temporarily, but the effects would be short term.)
This is what concerns the Fed. And there’s not a thing they can do about it. They can raise interest rates to the moon or chop them to zero, but they can’t make fully-trained workers appear out of the ether.
Is there a takeaway here?
Unfortunately, yes.
Don’t expect inflation to dissipate any time soon. And keep your inflation hedges in your portfolio.