The Days Ahead:

  • Personal Consumption Expenditure inflation.

This Week:

  • Services inflation is slower to fall than goods inflation.
  • It’s running 1% above target inflation in the U.S., Canada, U.K. and the EU.
  • Wages still need to catch up.
  • Cocoa prices at an all-time high and up 130% in six months.
  • The problem is not going away.
  • The Bank of Japan’s historic move gets no respect.
  • The Fed keeps its options open.

Why Services Inflation Runs High

At Cerity Partners we look at as many inflation indicators as we can. After all the BEA’s Consumer Price Index contains 90,000 items from 280,000 outlets. Then there are “sticky” price inflation measures, which look at price moves that don’t tend to change very often, like household furniture or motor vehicle fees. And there’s “trimmed mean” inflation, which excludes outliers for small and very large price changes. There’s also the Personal Consumption Expenditure index, which measures what people spend their money on and considers things like substitution.

Anyway, we first compare goods inflation to services inflation. Goods inflation took off during Covid-19 as people spent more on computers, furniture, cars and exercise machines. Things like used car prices and transportation rose 40% and 15% in 2022. As supply chains normalized, people tired of buying things, and goods inflation started to ease. In 2021, goods contributed 1.25% of the 3.50% core inflation, or 35% of the total. By 2023, goods were down to 0.31% of the 3.90% total, and just 8% of the total.

Goods inflation seems to have subsided but that leaves the question, why has services inflation not fallen as much? And will it in the future?

Services inflation is harder to cure. Most goods can be produced at higher volumes and at lower prices. Soon demand is satisfied and inflation eases. But services are tougher to control because the one cost they all face is higher wages. Productivity gains in services are hard to find. A top lawyer can only work so many hours a week. A top chef, hairdresser, designer or musician can only cook, cut, develop or compose a finite amount of ideas at one time. At some point, she can charge more and see if the market takes the price increase. But productivity gains quickly flatten.

Large parts of developed economies depend on services ranging from restaurants to health care, airlines, hotels and recreation. For years, service inflation was low. Not anymore.

Figure 1 - Chart showing services inflation
Source: FactSet, 03/18/2024

This chart shows service inflation running at a benign 1% to 3% for years but suddenly spike up to between 4% to 6% beginning in 2022. It’s the highest services inflation across the US, EU, Canada and the UK in over 30 years.  

One of the reasons is a catch up in wages. Here’s the annual wage growth in the same four countries. They were flat for many years in the 0% to 3% range and have now settled at around 3.5% to 6.0%.

Figure 2 - Chart showing BIS stats on recovered wages
Source: FactSet, BIS, Cerity Partners

The Bank for International Settlements (BIS), the central bankers’ central bank, took a look at this and concluded that wages were rising ahead of inflation targets, that there remains labor market tightness and that real wages still had some ground to recover from pre-Covid-19 trends.

Figure 2 - Chart showing services inflation in advanced economies
Source: FactSet, BIS, Cerity Partners

The chart above shows service inflation dipping during Covid-19, and quickly rise as economies reopened and reach the same level as pre-2020. But they’ve only recovered to the pre-Covid-19 levels. If we use a trend (the dashed line), service inflation has some way to go before it reaches its pre-Covid-19 levels.

So, there’s  a catch up in wages. The BIS gives two reasons for higher services inflation.

One, services inflation in advanced economies has run about 1% above core goods inflation for years because, as per capita income rises, so does the demand for services. That makes sense. Once you’ve remodeled your kitchen, or bought that Porsche 911 you always wanted, the next thing to buy is “experiences”: a once-in-a-lifetime vacation, tickets to the latest Rolling Stones tour (at $900) or more eating out.

Second, there’s a tendency that as wages rise in high-productivity goods businesses, costs are pushed up in labor intensive services businesses. This may be because both industries compete for talent, or employees in higher productivity industries have more discretionary spending and so are willing to pay more. This is a well-known effect (the Baumol’s cost disease) and goes some way to explain why economic growth can slow even as high productivity industries do well.

At a more concrete level, it means that as prices for things like cars, phones and TVs fall, the prices of health care, veterinarians, child care, teaching and fitness coaching all rise. As an economy grows, it’s inevitable that services get more expensive.

Anyway, the BIS’ bottom line is that service prices may continue to grow more than other prices for at least another year. And it will be mostly due to wage pressure, not widening margins. It’s not all gloom. Right at the end we read:

“On one hand, artificial intelligence and digitalization could increase productivity and lower costs, perhaps disproportionately in the services sector. On the other hand, ageing and labour scarcity could work in the opposite direction for this labor-intensive [i.e. services] sector.”

We land somewhere in the middle (what did you expect?). Wages have some catching up to do and the road to 2% may be long and winding. But it’s heading in the right direction. Just keep an eye out for those services.  

Record Cocoa Prices

Services account for about 60% of the inflation index so commands a lot of attention. Cocoa, meanwhile, isn’t even in the index. The nearest we could find is “cakes and cookies” at 0.19%.

The world consumes around 5 million tonnes of cocoa beans a year or 11 billion pounds, slightly less than the amount of coffee produced. Some 73% of global production comes from Africa with Côte d’Ivoire (Ivory Coast) and Ghana producing 57% of the total.

Cocoa is a finicky crop and only grows 20⁰ north and south of the equator. However, most of the supply comes from a band of 10⁰ north and south. And while there are 51 cocoa producing countries, the top three, which includes Indonesia, grow 70% of the world’s supply. The U.S. produces around 32 tonnes of cocoa, all in Hawaii, where it’s known by its raw form cacao.

Growing cocoa beans is difficult! It takes six years for a cocoa tree to flower and after that, farmers can expect two harvests a year for another 20 years. Conditions must be exact. A cocoa root is six to seven feet deep. They need plenty of water, good drainage, shade and shelter. They’re often planted with fruit and hardwood trees. Over 90% of the world’s cocoa is grown on family farms of 12 acres or less. The crop provides a livelihood for around 50 million people, although that includes processed cocoa and finished products like butter and chocolate. Ninety percent of farmers do not earn a living income from cocoa beans, although some companies are trying to change that.

The global market for raw cocoa beans was worth around $10 billion a year a few years ago and prices fluctuated between $2,200 to $3,000 a ton 90% of the time for the last 50 years. Recently, however, they’ve gone parabolic.

Figure 4 -  Chart showing cocoa prices
Source: FactSet, 03/19/2024

In the last six months, prices climbed 140% to $8,258 a ton. The market is now worth between $20 billion to $30 billion, depending on contract and spot prices.

What happened? Weather, disease and speculation.

Ivory Coast and Ghana are particularly susceptible to dry, El Niño weather which meant yields fell. Dryer conditions and deforestation also led to more disease and infections. These can be treated but it means destroying large parts of the crop or substituting normal trees with hardier versions that have lower yields and shorter life cycles.

At the same time the EU banned cocoa grown in deforested areas. Cocoa is stored in warehouses for up to 18 months before being processed into finished food. The EU ban may require that warehoused beans be destroyed if they cannot prove their provenance. The crop shortage and prospect of destroying warehoused beans was enough to attract speculative funds into the cocoa market. It’s always tough to know exactly how much investment funds are buying cocoa but recent estimates show $9 billion in long positions across European funds. That’s equivalent to half the world’s output.

What’s next? Higher prices for consumers everywhere for sure and probably better harvests two years from now. But farmers won’t see any gain. In both Ghana and Ivory Coast, producer prices are highly regulated. Companies like Hershey’s, Meiji, Lindt & Sprüngli and Mondelez have already warned about margins. It’s a tough market and one where we may not see much relief in consumer prices.

Story of Two Central Banks

Central banks these days are masters of “forward guidance” which means they lead, leak or tell markets what they’re thinking and plan to do. So, the two big meetings this week at the Federal Reserve (Fed) and the Bank of Japan (BOJ), left bond markets mostly unchanged.

First the BOJ reversed a 17-year-old policy of negative rates with a new policy rate of 0.1%. This seems paltry by Fed or ECB standards but Japan has been fighting deflation and an ageing and declining population for years. The BOJ has a vast balance sheet of assets and in recent years added corporate bonds, stocks, real estate investment trusts, and commercial paper in addition to regular government bonds. All that will stop except for government bonds.

It also dropped the yield control of 10-year bonds. In the last few years, the BOJ had targeted 0%, 0.25% and 0.50% for 10-year government bonds. That mechanism has now “fulfilled [its] role” and is over. In theory the 10-year bond can now float to wherever the market wants but in reality, with the BOJ still buying bonds, the rate is capped at around 1%.

With one bound the BOJ is seemingly free of some very strange policy decisions. But the markets had mostly priced in the moves. The Yen weakened, the bond market rallied and stocks rose in the days before the announcement. It was a classic case of “buy the rumor, sell the fact.”

Over at the Fed, the question was would officials signal three cuts for 2024 or two? In the end they left it at three, projecting that rate would cut to 4.6% at the end of 2024 from 5.25% today. But there were other changes in the “dot plots”.

Figure 5 - Dot plots for March 2024
Source: Federal Reserve

For 2025 and 2026, the projections went up from 3.6% to 3.9% and from 2.9% to 3.1%, respectively.

The Fed doesn’t seem fazed by recent misses in inflation. If it had, it would presumably have lowered the number of forecasted cuts for 2024. It also talked about how and when the Fed will stop the balance sheet run-off in Treasury and MBS securities which started in early 2022. Chair Powell talked about a “lower pace…fairly soon” and a repeat of the plan to own an all-Treasury portfolio.

Finally, he does not seem worried about any “cracks” in the jobs market. Nor did he take May off the table for a possible cut.

Markets liked what they heard. It confirmed the steady GDP, improved inflation and steady employment outlook.

The Bottom Line

The Fed meeting sucked most of the oxygen out of the room this week but we also saw existing home sales rise to their highest in a year and with a small uptick in the average price. Existing home sales aren’t that economically important. They transfer an existing asset, which makes money for realtors and lawyers, but they don’t need the labor and materials required of housing starts. But they are useful indicators of optimism.

The Philly Fed showed strength with new orders up. Even the U.S. current account deficit came in at $194 billion for Q4 2024 and $818 billion for the year. That’s a 15% improvement over 2022. Not that many people follow it these days but if they did it would be dollar positive.

The Swiss National Bank became the first major central bank to lower rates for this cycle. The Swiss have something of a charmed economy with historically low inflation, full employment but also a very strong currency which, in a country where trade is 140% of GDP, doesn’t help. The franc fell and stocks went up.

Stocks rose on the Fed news reaching record highs again and up 10% since January 1st. Small and mid-cap stocks also had a good week as did the equal weighted S&P 500. That means the rally became broader based. European and Japanese stocks also had a good week. It seems markets are fine with central bank actions.

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Art of the Week: Kylie Manning (b. 1983)

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