Inflation: Fed rate hikes and impact on services sector

Activity in the services sector grew for the seventh straight month in July, according to the ISM services index. Allianz Chief Economist Ludovic Subran joins Yahoo Finance Live to discuss the latest data and what to watch in the services sector.

Regarding inflation, Subran says, "We do believe that the Fed is actually contributing to half of the disinflation." Subran added, "The big question now is how long can the Fed keep interest rates high, and whether this could create even less growth going forward."

Video Transcript

JULIE HYMAN: The latest services data just out this morning, as we were talking about seeing slowing last month in those services numbers to some extent and still seeing a little bit of persistence in pricing, which is interesting here. 52.7 was the read from the Institute for Supply Management. That was down 1.2 points. So still expanding here, but expanding at a slower pace. And also, the measure of employment at service providers showed there was not much hiring during the month. Interesting there.

Let's talk about the bigger economic picture right now with Ludovic Subran, who is Allianz chief economist. Ludovic, good to see you. So looking at this services data, it's actually quite interesting. Because we keep talking about anecdotally how big services is right now, travel, activities, concerts, et cetera. Does this show that maybe that momentum can't last forever?

LUDOVIC SUBRAN: Well, I think one thing is sure is that the excess savings that most American families have accrued during COVID for not traveling, not going on vacation, not going out is actually coming to an end as early as this September. So right in the back-to-school's time. So I think that's a little bit what you start seeing in the services sector compared to what we saw in the ISM manufacturing, which was very good, which is all about labor hoarding, and the IRA, and the CHIPS Act, and everything that is being happening to reindustrialize America at a very fast speed, the so-called Bidenomics.

So services, you can't defy gravity for long. Because it's leisure spending. And we start seeing that the real disposable income of Americans is being indented by the still quite high inflation and the beginning of the monetary transmission into the cost of debt, cost of mortgage, and so forth into their disposable income.

JULIE HYMAN: Well, as you wrote in a recent note, you asked if we are seeing so-called immaculate disinflation. That is, will we continue to see that trajectory of inflation moderating without the economy tumbling into a recession? Do you think we will? Is that what it's-- I mean, that's what it's looked like kind of so far.

LUDOVIC SUBRAN: Yeah, it's super interesting to see how-- for example, there was this big discussion of whether the Fed at all is responsible for part, at least, of the disinflation. We do believe that the Fed is actually contributing to half of the disinflation. So it's not that immaculate. It's not that coincidental. The other part is really supply chain disruptions coming to an end. It's really the softening of the momentum.

And so this is why the big question now is, how long can the Fed keep interest rates high? And whether this could create even less growth going forward, especially as 24 is an electoral year. So we know-- if we remember 2016, that is quite a muddle-through time, quite a purgatory for growth. So the question here is whether this suffices to bring inflation down to 2% year-on-year by the middle of next year, for example. I tend to think it could, actually. Because the growth momentum is really going to that direction. And all the other international pressures are coming to an end.

JULIE HYMAN: Do you think the Fed will raise again in September? Or do you think it's going to be patient here and see if all of this is making its way through the system?

LUDOVIC SUBRAN: That's a good question. And I don't have my crystal ball. But I believe they may have to do one last hike, unfortunately. Why? Because there are still some [INAUDIBLE] pressures on wages in the US. And so the Q2 numbers were really high. So I would be in the camp of a possible hike again in September. But a lot can happen by then. Because you've seen what happened with the Fitch downgrade.

And there are a lot of discussion now about what is good fiscal and whether there's been not too much fiscal so far. So it's 50/50. But I would still think that one more hike could be needed because of still the slightly overheated and the slightly risks of having long-lasting inflationary pressures. And we know how detrimental it is to the most vulnerable of Americans.

JULIE HYMAN: In a recent note, I want to ask you about global economies and in particular, European economies. Because of course, you're a global economist, and you were out with a note recently looking at the US GDP situation, which has been quite resilient and the European situation, which has been less so. What does the trajectory look like there as we go through the next 6 to 12 months?

LUDOVIC SUBRAN: Well, I'm going back to my fiscal stimulus point. What is fascinating is that the countries in Europe that have been plunged into recession, like Germany, are entirely due of efforts to consolidate spending. Whereas in the US here, there is this prolonged cloud nine period with the debt ceiling. And so somehow, there is a recession-avoiding syndrome by spending more money.

And so this is really one of the major difference we see between the US and Europe now, is of course, we don't have the same reasons to worry. I would say in Europe, we still have this energy Damocles sword and the risk of having much more trouble as we don't have necessarily the right sources of energy.

But I would say the manufacturing sector is adapting fast. We're all affected also by, I would say, a sluggish Chinese demand. But the big issue is we both, the US and Europe, have been fueling a lot of the growth over the past, I would say, 3/4 from very profligate fiscal. And Europe is a bit more anal when it comes to reducing fiscal spending. Just because we have a set of rules that have been changing but they are still there. Whereas America seems to be a bit on the way to elections again, less concern about those rules.

And so I think that's a major ingredient of growth that is different. And that's why we are actually tiptoeing with recession over the past couple of quarters in Europe. Whereas America is still surfing on a soft momentum-ish type of situation.

JULIE HYMAN: So so far, not being anal, to your word, like not having any limits at all, really, not-- whether it's-- whichever party the administration is, they've thrown a lot of money at it. Do you agree with Fitch that that is a problem? And if it is a problem, people have been saying it's a problem for a long time and it hasn't yet been. What would cause it to finally be a problem?

LUDOVIC SUBRAN: Look, I think as long as people believe that the US Treasury is doing their job. Of course, the past few months have been a bit weird with this idea of the Republican Party even calling for an organized default. That is the ultimate threat. But I think every saver sees that the US Treasuries is a safe asset. And so I don't believe in a big Armageddon when it comes to the trustworthiness of the US government. So that's a little bit why there is no reason to consolidate for the sake of consolidating.

And we've been through that in Europe with the austerity crisis of 2012. And we've been paying the high price for that. One of the issue is, of course, the cost effectiveness of some of the spending. One of the other issue is also how much more industrial policy can be funded by the public money without asking really about the direct effect on growth and private sector crowding-in effect. I think one of the questions now is that there's been a lot of money out of the door. It continues to be quite a lot. I mean, the IRA is $500 billion over 10 years.

That's a lot of money. And a lot of companies are banking on this. Is it the right use of taxpayers' money in America? That's really the question one should ask. So it's all about the quality of the spending and the crowding-in effect from the private sector. Look, climate change is a big problem. So any money, any dollar is a good dollar. But I think there are ways to make sure this is not creating a lot too much inflation, which is also what we've seen in the US in 2021 and 2022.

JULIE HYMAN: Yeah, most definitely. And I think the execution of all of that deployment is going to be really fascinating as it is given out. Ludovic, thank you so much. Good to see you. Ludovic Subran--

LUDOVIC SUBRAN: Thank you.

JULIE HYMAN: --is Allianz chief economist. Thank you.