There were a couple of ways that the latest inflation data could have gone, and Friday’s result was clearly the most positive of the not-great potential outcomes. Following a hot quarterly inflation print on Thursday, investors learned from the monthly numbers that most of the heat came at the start of the year. Yesterday’s news, in other words. Still, it’s become clear that markets may have to brace for a few more months of disappointment, and that the data will probably keep the Federal Reserve’s policy rate at its current 5.25%-5.5% for most of 2024.
The Bureau of Economic Analysis said Friday that its core personal consumption expenditures deflator — the Fed’s preferred inflation gauge — rose 0.32% in March from the previous month, with January’s number revised up to 0.5% and February coming in a hair higher at 0.27% (I’m going to the second decimal place because such is the level of scrutiny and handwringing around these numbers.) From a momentum standpoint, it’s a welcome development that the worst of the problem is now a full three months behind us, leaving year-on-year core PCE at 2.8% (about 80 basis points above the Fed’s target of 2%). Not exactly a hyperinflationary crisis!
Here’s the bad news, however: Unfavorable base effects now mean that you’d need monthly core PCE reports of under 0.2% for the rest of the year to meet the Fed’s year-end forecast for 2.6%. And though I hate to discourage my fellow optimists, that’s not going to happen, and as a result, our hoped-for three rate cuts this year probably aren’t going to materialize either (one cut is the most likely outcome, and we’ll be lucky if we get two.) And according to Inflation Insights LLC President Omair Sharif, the index is due for a bump from the US stock-market rally (which mechanically translates into higher portfolio management inflation) and a boost in reported physicians services, stemming from a government Medicare fee increase.
In the medium run though, it’s still reasonable to expect more good news than bad.
Most of the PCE inflation heat continues to come from the extremely lagging housing category and other idiosyncratic factors including financial services and health care, which is affected both by government negotiations and the long-tail of health care wage inflation during the pandemic. Both those drivers should cool into the end of the year and 2025; we’ve just underestimated how long it would take for the lags to play out. Likewise, in another closely followed gauge of prices in the economy, auto insurance has been pressuring the consumer price index significantly higher — a lagged reflection of the surge in car and parts prices in 2021.
The hawks would have you believe that inflation has become a story of an economy juiced by excess demand and the wealth-effect from a hot stock market, but I still doubt that’s the case. A report Thursday showed that gross domestic product expanded at a reasonable 1.6% annualized pace in the first quarter, helped by resilient (but not over-the-top) consumption spending. The ‘economy’s too hot’ story falls apart when you realize that the parts of the inflation basket that have been the hottest (housing, health care, financial services and insurance) are not necessarily the parts of the real economy that have been the strongest.
Durable and nondurable goods have had negligible impacts on the inflation numbers, and the hot service categories in recent months don’t exactly scream “overheating economy” (aside from the aforementioned housing and health care, legal services and funeral services also come to mind.) I’ll be watching items such as recreation services and consumer discretionary goods as potential canaries in the coalmine that the overheating narrative is actually coming true, but as of today, I don’t see it.
In other words, Friday’s data showed that the case for disinflation remains intact. Unfortunately, it may take some thick skin to remain an optimist in this environment, as the near-term data continues to complicate the situation and the market embraces a far uglier view of the future.
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