PCE Inflation Ticks Lower, So Does Spending
PCE inflation lifts confidence on the Fed, but PCE casts some doubt on sustainable consumer demand growth.
The PCE inflation news was a favorable part of the latest release with a trend consistent with CPI.
The lower consumption metrics were a negative factor in the economic picture while higher savings rates at 3.4% can be seen as a mixed blessing after 5 of the prior 6 months posted 2% handles.
The natural question is whether this is a sign for the Fed as they weigh supply-demand and whether this signals consumption getting a bit tired.
The personal income numbers are more important than usual as the Fed looks for hints of weakness from the demand side. The PCE inflation lines punch above their weight just on the basis that the Fed prefers it over CPI. The market more broadly tends to focus on the CPI metrics, but if the Fed cares the market must.
The “cut to the chase” news on the PCE inflation was that it dropped from 5.5% in Nov 2022 to 5.0%. Core PCE (ex-food, energy) also dropped from 4.7% to 4.4%. As we have highlighted in past commentaries, the negative real fed funds vs. CPI and PCE bucks history. The period before the crisis posted fed funds above inflation as we update in the charts herein. With the crisis of late 2008, ZIRP took over until late 2015 before ZIRP was revisited with COVID. That means a positive fed funds differential vs. CPI or PCE has been hard to come by since 2008.
The Dec 2022 PCE inflation came in at 5.0%, down from 5.5% in Nov 2022 vs. the high of 7.0% in June 2022. The Core PCE numbers posted 4.4%, down from 4.7% in Nov 2022 and the 2022 high of 5.4% in March 2022. Whether you are looking at CPI or PCE and whether it is Core or Noncore, there is a history in place that tells a story. There is also a history around the relationship of CPI and PCE (CPI usually higher than PCE).
We looked at those histories before (see Fed Funds vs. PCE Index: What is Normal? 10-31-22). The main takeaway is that the relationships in place in the post-crisis years are very much distorted with inflation above fed funds in what is supposed to be a tightening cycle. As detailed in the chart above, the period before 2008 saw fed funds post a median 2.9 points higher than PCE inflation. That all got turned upside down with the crisis monetary response followed by the COVID crisis. The current upper limit on the fed funds target is 4.5% as of mid-Dec 2022, and that is still below PCE inflation and just above Core PCE. The negative differential between funds and CPI is even greater (see CPI Wrap for 2022: The Beginning of the End? 1-12-23).
There is no question that the Fed has been in a hiking cycle and is likely to add another 25 bps next week, so the upper target for fed funds will at least be above something (Core PCE). The hesitation of the Fed to send easier signals of what may lie ahead has some support from the past time series on what has worked vs. what has not. The actions under Volcker worked while the critique of policies in late 1973 to 1975 and in the following years (before Volcker’s arrival in 1979) have a different message in the literature. The pre-Volcker Fed took the blame for the inflation resurgence in the minds of many.
The weaker PCE may help with the Fed’s sense of mission even if at the same time these weaker PCE numbers feed the more bearish camp on where the economy is headed. The 4Q22 GDP line items had a decent PCE number in the mix yesterday (see GDP 4Q22: Thin Sliced 1-26-23). The data from today in the personal income release is calling the next leg of PCE into question and signaling a consumer fade. The debate rolls on. It may take a few more months of CPI and PCE data and jobs reports to shift the market (or the Fed) more toward one side or the other with more confidence.
For those who dread the monthly Personal Income and Outlays release, the tables attached to the release break out some line items on the direction of goods and services in the PCE lines (Table 7, 8). The durables line was down in Aug, Sept, Nov, and Dec (4 of 5 months) while services was flat in Dec. The goods weakness vs. services is consistent with the other data releases around the monthly econ data circuit. The Services plateau seen in the personal income release will need more proof in coming months. Services is where the inflation risk has been more of a focus, so the Fed will be watching closely.