The inflation the Fed can't fix: your haircut and your dentist

The August consumer price index showed core prices up 0.6 per cent on the month, and with it the limits of monetary policy. Central bankers like to look precise, as though the price of overnight money could reset every price tag in the economy. Higher interest rates can quickly cut mortgage applications and force chip distributors to write down surplus stock. They have no direct route into labour-intensive services. The Federal Reserve can break the housing market, but it cannot set the price of a haircut or a trip to the dentist.

This is the centre of the current inflation problem. Core goods inflation has started to turn down as supply chains clear and shops fill with unsold electronics. Core services excluding housing follow different rules. Dry cleaners, healthcare providers, mechanics and hotels use few industrial raw materials and little international shipping. Their biggest input is local labour.

A report that broke the rally

The figures landed on 13 September and undid a summer of hope. Headline inflation eased only to 8.3 per cent on the year as petrol prices fell, while core inflation rose to 6.3 per cent, and the S&P 500 dropped more than 4 per cent that day, its worst session since June 2020. Traders who had priced a gentler pace of tightening now expect the Fed, which meets this week, to deliver at least another 75 basis points.

Wages drive the bill

In labour-intensive service businesses, pay accounts for sixty to eighty per cent of operating costs. With hourly earnings rising at more than five per cent a year, owners can either accept thinner margins or pass the higher wage bill on to customers. Consumer credit is easy to come by and households still have savings to draw on, so service firms have found customers surprisingly willing to pay more.

A dentist facing higher pay demands from hygienists and receptionists cannot move the practice to Vietnam or have software do the cleaning. The price of a check-up simply goes up. These services are essential and local, so demand barely responds to price. The increases feed into services inflation, justify the next round of wage claims and create a loop that overnight interest rates hardly touch.

Economists have had a name for this since the 1960s. William Baumol observed that a string quartet needs as many players as it did in Mozart's day, so services with little productivity growth must raise prices whenever wages elsewhere rise. The effect normally works slowly, adding a steady premium to services inflation. With about two job openings for every unemployed American, it has been running at full speed.

The pressure is greatest at the bottom of the pay scale. Hourly pay has been rising fastest in leisure and hospitality, the sector that shed the most jobs in the lockdowns of 2020 and has struggled most to rehire. Restaurants, hotels and personal-care businesses therefore face the steepest increases in their largest cost, and they are the ones most likely to pass it on in menu prices, room rates and appointment fees.

A blunt instrument

The Fed's problem is that monetary policy works indirectly. It cannot order service firms to cut prices. It can only depress demand until their revenues fall far enough that they freeze hiring and lay people off. To bring down the price of a haircut, the Fed has to raise borrowing costs until customers feel poor enough to skip one, or until salon owners go bust.

The process is wasteful, and it works with long and unpredictable lags. Service businesses usually review their prices once or twice a year, so today's wage pressure will keep pushing up service prices well into the middle of 2023. Tightening against that momentum means driving the economy into a deep downturn just to slow wage growth in industries that do not trade across borders.

The costs of that approach fall unevenly. Interest-sensitive industries such as housebuilding, car dealing and mortgage broking absorb the first blows, although their prices are not the ones causing the trouble. The service businesses at the centre of the problem feel the squeeze only later, once their customers' jobs and incomes are hit, so the Fed ends up cooling one part of the economy in order to reach another.

What Volcker paid

The last time the Fed set out to break a wage-price spiral, the bill was settled in jobs. Under Paul Volcker the policy rate went above 19 per cent in 1981, and unemployment reached 10.8 per cent at the end of 1982 before inflation was reliably tamed. Today's spiral is milder and the Fed has started earlier, but the mechanism is the same: services prices come down only once workers lose the bargaining power to push wages up.

Workers are not ahead

One objection deserves a hearing. With headline inflation at 8.3 per cent and pay growing at a little over 5 per cent, the typical worker's real wage is falling, so on this reading wages are chasing prices rather than driving them. That is true of purchasing power, and it is why a full 1970s-style spiral is unlikely. It does not help the dentist, whose costs are set by nominal pay: a hygienist's rise of 5 per cent still has to be recovered from patients, and workers still behind inflation will keep pressing for more at each annual review.

The hopeful reading is that labour supply will do the Fed's work. Participation has been creeping back, the post-lockdown surge in job-switching should fade as workers settle, and a cooling housing market will slow hiring by builders and estate agents. If wage growth drifts back towards a pace consistent with the Fed's 2 per cent target, services inflation could ease without mass lay-offs. The quarterly Employment Cost Index, which strips out shifts in the mix of jobs, will show first whether that is happening, and so far the evidence is thin; the next reading is due at the end of October.

Stubborn services inflation explains the harder language from central bankers in recent weeks. Services prices will keep climbing into mid-2023 unless the labour market loosens a good deal, and until then cheaper goods will do little for the inflation figures. The Fed's rate rises may win in the end, but the damage will spread across the real economy long before any dentist cuts fees, and it will land first on the housing and car industries that did least to cause the problem.