U.S. Services Sector Faces Persistent Inflation Threat, Impacts Interest Rate Outlook

U.S. Services Sector Faces Persistent Inflation Threat, Impacts Interest Rate Outlook

U.S. Services Sector, Persistent price increases in the U.S. service sector have cast a shadow over hopes for a smooth economic soft landing, delaying expectations for interest rate cuts in 2024 and challenging the trajectory of monetary policy.

Traders are now revising their expectations, anticipating a decline of 75 basis points in overnight interest rates by the end of the year. This adjustment comes as a response to recent data indicating that prices in the service sector have risen more rapidly than anticipated, as revealed in the February 13 release.

Just a month ago, traders had anticipated more aggressive rate cuts of up to 150 basis points, with the first cut possibly as early as March, reflecting a more optimistic outlook for a soft landing.

The persistence of price rises should not be surprising, given the evidence that many businesses, particularly in the service sector, still perceive room to increase prices without sacrificing revenues or profits.

While U.S. consumer prices rose by 3.1% over the twelve months ending in January 2024, down from a peak increase of 9.0% ending in June 2022, there has been no significant or sustained slowdown in the overall inflation rate since mid-2023. This underscores the stabilization of pricing power following the business cycle slowdown experienced in the second and third quarters of 2023.

Contrary to the decline in prices for goods and commodities, prices in the service sector, which is larger and more labor-intensive, have been escalating. Goods prices decreased at an annualized rate of 3.0% over the three months ending in January, driven by a fall in energy commodities at an annualized rate of 10.2%. In contrast, service prices surged at an annualized rate of 6.5% during the same period, marking a significant acceleration from 3.6% in the three months ending in May 2023.

The uptick in service sector prices aligns with the recovery of service sector activity after a mid-cycle slowdown observed since the second quarter of 2023. The Institute for Supply Management’s (ISM) service sector purchasing index climbed to 53.4 in January 2024, reflecting a rebound from a low of 51.0 in May 2023. Additionally, service sector firms reported widespread increases in the prices they pay for materials and services, contributing to the escalation.

Unlike the goods sector, where costs are influenced by raw materials, energy, and distribution, services businesses are more reliant on labor and less exposed to import competition. As a result, the impact of falling costs, experienced by merchandise producers, has been less pronounced in the service sector.

The rate at which service sector prices are climbing, more than twice as fast as before the onset of the pandemic in 2020, poses challenges to implementing sharp interest rate reductions aimed at stimulating consumer and business spending.

While some economists advocate for interest rate cuts to achieve a more “neutral” level from the current “restrictive” setting and ensure a soft landing, there are concerns that rapid rate cuts could exacerbate inflationary pressures in the service sector, perpetuating the cycle of price increases.

While rate hikes in 2022/23 have influenced purchases of interest-rate sensitive items like motor vehicles, particularly premium electric vehicles, the service sector does not yet exhibit signs of being constrained by high interest rates, as evidenced by the willingness of businesses to raise prices rapidly.

The resistance to early and aggressive rate reductions reflects the risk of entrenching faster price increases in the service sector. Policymakers must navigate this delicate balance to mitigate the threat of a hard landing in 2024.

In conclusion, the persistence of inflationary pressures in the U.S. service sector complicates the path to a soft landing and warrants a cautious approach to monetary policy adjustments. As economic stakeholders recalibrate their expectations, the trajectory of interest rates remains uncertain amid the evolving dynamics of inflation and economic recovery.

Related Columns:

• U.S. Manufacturers Poised for Resumed Growth, Diesel Shortage (February 2, 2024)
• Persistent U.S. Services Inflation Dampens Oil Outlook (October 13, 2023)
• Recession or Not, U.S. Economy is Losing Momentum (May 5, 2023)

John Kemp is a Reuters market analyst. The views expressed are his own. Follow his commentary on X.

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