Sticky Inflation Provides Ammo for Another Fed Hike
It is getting harder and harder to justify not raising rates at the next meeting of the Federal Open Market Committee.
The Bureau of Economic Analysis on Friday released its personal-consumption expenditures (PCE) price index for April. Wall Street had been expecting the price index to climb 0.3 percent after inching up by just 0.1 percent in March. Since this index comes out weeks after the Labor Department’s consumer price and producer price index, it should be fairly predictable based on similar data already received.
Yet we got an upside surprise. PCE inflation rose by four-tenths of a percentage point. Over the past 12 months, PCE inflation is up 4.4 percent, also a tenth of a point higher than expected and up two-tenths from the March reading.
Core PCE inflation, which excludes food and energy prices, were likewise up 0.4 percent from the prior month. From a year ago, core prices are 4.7 percent. Both were higher than the March. numbers and higher than Wall Street expected.
Core PCE inflation has been in a tight range of 4.6 to 4.7 for five months. This suggests that the Fed has not made much progress at all when it comes to inflation.
Watching What the Fed Watches
The Federal Reserve uses PCE inflation for its two percent target as well as in the Summary of Economic Projections (SEP) that gets released every other FOMC meeting. Fed officials also forecast core PCE inflation in the SEP. While Fed Chair Jerome Powell and others have emphasized that they also look at other measures of inflation, PCE inflation is certainly viewed as the Fed’s “favored” metric. So, it gets a lot of attention from anyone trying to figure out where rates are heading.
The last SEP was released at the March meeting. It showed that the median expectation for headline PCE inflation for 2023 was 3.3 percent, up from 3.1 percent in the prior summary from December. The range of projections was for between 2.8 percent and 4.1 percent. Core PCE was expected to come in at 3.6 percent for the year, up from 3.5 percent.
Those projections now look unrealistic. It would take a very severe downturn in inflation in the last eight months of the year to bring headline down to 3.3 percent and core down to 3.6 percent. Getting there would require a large pullback in consumer spending and a big uptick in unemployment. This means it is likely that Fed officials will raise their forecasts for inflation at the next meeting.
One alternative metric that has been singled out by Powell several times is PCE core services inflation excluding housing. This rose 0.42 percent in April, which amounts to a 5.2 percent annualized rate. Powell would probably look at the last three month annualized rate, which comes out to 4.4 percent. The six month annualized rate is 4.9 percent, and the 12 month is 4.9 percent. As Nick Timiraos of the Wall Street Journal pointed out, this measure has basically gone sideways for several months.
Core PCE had seen goods disinflation offset by shelter inflation. Now the acceleration in shelter is slowing but so is the goods disinflation.
Core services ex-housing on a 12 month basis is holding steady
April: 4.6%
Mar 4.6%
Feb 4.6%
Jan 4.7% pic.twitter.com/ENPqVUrBf0— Nick Timiraos (@NickTimiraos) May 26, 2023
The second point Timiraos makes is also worth highlighting. The disinflation in core goods prices has slowed, offsetting the leveling out of housing inflation. Many economists had been expecting outright deflation—meaning falling prices—in goods after last year’s huge increases. That has not happened.
In his speech earlier this week, Fed Governor Christopher Waller warned about this exact dynamic:
We’re hoping there will be a continued slowdown in goods price increases, but we aren’t seeing deflation in this category like we had pre-pandemic. A second concern is rent increases, which accounts for most of a category called housing services and is a sizable component of inflation. Lower rent increases from lease renewals last year are slowly making their way into the inflation data, but most recently, a rebound in the housing market is raising questions about how sustained those lower rent increases will be. While housing prices actually have less of a short-term effect on rents than one might think, this upturn in the housing market, which comes even with significantly higher mortgage rates, has raised questions about whether the benefit from the slowing in rent increases will last as long as we have been expecting.
The Median Is the Message
That is where inflation has been. Where is it going? For that we return to our old friends, median and trimmed mean inflation.
The Cleveland Fed calculates median PCE inflation each month, and we consider it a reasonably reliable guide to underlying inflationary forces that can allow for predictions about where inflation is likely to be in the months ahead. This was also up 0.4 percent for the month, exactly the same as headline and core. That’s a signal that inflation is no longer being pushed around by outlying factors but is now broad-based.
The only trend detectable in median PCE inflation is sideways. It has been 0.4 percent in five out of the last six months. The exception was in January, when it rose 0.6 percent. The message from this is that PCE inflation probably cannot be expected to move down much. It’s certainly not on a reliable path to two percent.
The Dallas Fed calculates 16 percent trimmed mean PCE inflation, which excludes eight percent on both ends of the basket of goods and services that goes into calculation of the PCE price index. This is another measure intended to reveal underlying inflation and provide a ground for forecasts of inflation’s trend. It is reported on an annualized basis for one month, six months, and 12 months. The one-month annualized figure for April was 4.4 percent, up from 3.8 percent in March and tied with February as the second-highest reading over the past six months. The six-month annualized trimmed mean is also 4.4 percent, exactly where it was in March. The 12-month annualized trimmed mean increased to 4.8 percent, up from 4.7 percent.
Like median inflation, trimmed mean is pointing toward inflation not coming down by much at all.
It is still possible that the Fed will decide to keep policy rates unchanged at its June meeting. A strong jobs report next Friday, however, could extinguish that possibility. The market is looking for around 180,000 jobs. Anything above 200,000 will create a lot of pressure for the Fed to hike. And even if the Fed does opt to hold rates unchanged, it is likely to send the message that this is a “skip” until the July meeting rather than the beginning of a long-term pause.
As Cleveland Federal Reserve President Loretta Mester said in an interview on Friday: “The data coming in this morning suggest we have more work to do.”
