Column: U.S. service sector inflation decelerates but remains high

LONDON, Aug 10 (Reuters) - U.S. service sector inflation has started to decelerate in response to a general slowdown in the economy and more cautious spending by households and businesses, but it is still running twice as fast as the Federal Reserve's target.

Services prices rose at an annualised rate of 8.1% over the three months to July, data from the U.S. Bureau of Labour Statistics (BLS) showed.

That was slower than the 9.9% increase over the three months to June, the highest for 40 years (“Consumer price index”, BLS, Aug. 10).

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But services prices were still rising at an annualised rate of 4.1% between June and July, roughly twice as fast as the U.S. central bank’s flexible average inflation target (FAIT) of a little over 2% per year.

Services inflation is often a better guide to underlying price pressures in the economy and is closely monitored by central banks officials.

(Chartbook: https://tmsnrt.rs/3SSHtWf)

Services price changes tend to be less volatile than for merchandise because they are less impacted by changes in the price of energy and raw materials.

However they are also more persistent and exhibit more inertia because wages, salaries and other worker compensation account for a larger share of total costs.

Service sector growth has cooled significantly since the start of the year based on purchasing managers’ surveys conducted by the Institute for Supply Management.

The ISM non-manufacturing activity index has slipped to 56.7 in July (66th percentile for all months since 1997) and 55.3 in June (45th percentile) from 58.3 in March (86th percentile) and 68.4 in November 2021 (a record).

Services account for more than 60% of consumer expenditures, and with the real earnings falling as wage rises fail to keep pace with price increases, some slowdown in service sector activity and inflation was inevitable.

Policymakers are likely to welcome signs that inflation has peaked but they will probably not relax in the short term.

The central bank’s interest rate policy path to achieving a soft landing for the economy remains extremely narrow (and may not in fact exist) because there is so little spare capacity in the economy.

There may still be some in the job market (where labour force participation is below pandemic levels) but there is little or no spare capacity in markets for energy and materials, manufacturing capacity and freight transport.

Even in the labour market, total compensation for private service sector workers was rising at an annualised rate of 6.6% in the second quarter, as demand for labour outstripped supply at prevailing rates.

The central bank needs significantly more disinflation to bring the rate of price and compensation increases down to its long-term target, which means further interest rate rises may be needed.

No central bank wants to push the economy into recession deliberately. But policymakers cannot afford to stop tightening monetary conditions too early without risking another flare up of inflation.

Related columns:

- U.S. manufacturing activity shows signs of peaking (Reuters, Aug. 9) read more

- U.S. diesel shortage shows economy hitting capacity limit (Reuters, Aug. 4) read more

- U.S. consumers sour on inflation despite financial cushion from pandemic (Reuters, July 15) read more

- U.S. service-sector inflation threatens commodity prices (Reuters, July 7) read more

John Kemp is a Reuters market analyst. The views expressed are his own

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Editing by Barbara Lewis

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John Kemp is a senior market analyst specializing in oil and energy systems. Before joining Reuters in 2008, he was a trading analyst at Sempra Commodities, now part of JPMorgan, and an economic analyst at Oxford Analytica. His interests include all aspects of energy technology, history, diplomacy, derivative markets, risk management, policy and transitions.