PCE Inflation: Wild History, Recurring Oil Volatility

We frame PCE and Core PCE vs. oil since the 70s. The disconnects usually see oil as the recurring culprit.

The Personal Income release PCE data on Friday was reassuring on inflation but unnerving on the business cycle (see PCE Inflation Ticks Lower, So Does Spending 1-27-23). Our quick look on Friday was to frame fed funds vs. PCE inflation and the differentials across time. The fact that PCE inflation minus fed funds is still negative is significant in historical context even if that concept has been muffled after years of ZIRP, QE, and minimal front end rates. In this note, we look back across the PCE and Core PCE differential history.

We use these historical charts as our own version of a memory jogger and refresher. The 2020-2021 time frame was especially distinctive in the areas of personal income and PCE. Trying to track multicycle timelines is always a good idea in case people start to generalize based on the post-crisis periods defined by ZIRP and QE. We already saw plenty of wealth managers making their calls on how bonds and stock perform relative to one another and how they can toggle back and forth to mitigate portfolio risk. Many of those managers forget the 1970s and early 1980s existed. They paid a price (or their clients did) in performance. 

Those who downplay headline PCE inflation to focus on Core might be forgetting that food and energy swings keep happening and might even be called recurring. This will remain the case in a world of shale and with Russia in the West’s penalty box. Meanwhile, OPEC is always a wildcard.

The headline swings in oil and gas take a very real economic toll that require a policy response at a number of levels (from farm and household assistance programs to energy investment incentives, etc.), but that is outside the Fed’s direct line of influence. In addition, the oil markets are shaped by global forces and the same is increasingly true of natural gas with the growing interconnectedness of LNG markets.

The PCE Inflation vs. Core PCE history…

Below we plot PCE vs. Core PCE with some notations of events that were unfolding and drove some disconnects between the two.

The PCE line and Core PCE (ex-food, energy) track very closely across most years, but the divergence higher or lower often wraps around oil shocks (up or down) followed by oil price recoveries from that shock. Food inflation also played a major role along the way when categories of food swung around for various reasons whether in crops or along the protein chain. The occasional high teen and 20% inflation line in food is something you don’t see very often. In contrast, oil volatility seems like a cyclical constant over the years.

The energy factor shows up in force in the timeline with spikes and sharp drops across each decade. The Arab Oil Embargo of Oct 1973 to March 1974 was a landmark event that shook the major economies and certainly the US. The Iranian Oil Crisis of 1979 came with the revolution, but the oil strikes in 1978 in Iran with all the domestic turmoil had already been weighing on the oil markets. That was a period of extreme US dependence on OPEC for oil and a period when natural gas markets were in turmoil with the US worried about “running out of natural gas.” That was the period when many onerous take-or-pay contracts were negotiated by the pipelines. In those days, pipelines were merchants and not highways.  Even the most knowledgeable in the energy markets were in panic mode.

The chart shows the oil market crashes driving deflation in energy periodically and driving PCE below Core. We summarize a few of the later events below:

1986 oil patch crisis: The 1986 oil crash was infamous and brought a brutal regional contraction in the “oil patch” states.  Banks in TX, OK, LA, and CO took major hits with many seized and/or merged into other regionals and some major banks.  The oil crisis and weak refined product prices into 1987 and helped drive CPI materially lower to a 1% handle in 1986 (Volcker does not get all the credit). The oil markets weakened again in late 1988 when the Iraq-Iran war ended (1980-1988).

1990 Middle East on war footing: The Middle east began to regroup after Iran and Iraq ended their war until new disruptions and a new “war” (of sorts) erupted after the Aug 1990 invasion of Kuwait by Iraq. The US economy was slowing badly by late 1989, and the oil spike in 1990 was the last straw with the recession beginning on July 1990 (the date was set retroactively, see Business Cycles: The Recession Dating Game 10-10-22).

We would argue that 1989 was already sending the US into recession and the financial system was in turmoil as we cover in other commentaries (see UST Curve History: Credit Cycle Peaks 10-12-22). The 1990 Desert Storm war set the stage for later disruptions such as 9/11 as extremism rose up in the Mideast and the US got even more involved with the 2003 Iraq War.

The TMT bubble and 2001 recession: The oil markets had tanked in 1998 to as low as $10 and then stayed weak into 1999.  In 2000, oil was back to a $30 handle as inflation was rising. At that time, the Fed was tightening into a brutal capital markets period that only saw a very mild economic contraction (see How Do You Like Your Landing? Hard or Soft? Part 2 12-28-22).  9/11 and a lot of bad news in the markets soon arrived. The period in the 2000 to 2002 stretch also saw the mildest recession in postwar history but also the longest default cycle. We had a soft landing in the economy but a hard landing in the capital markets.

The 2008 oil spike: With the housing bubble so ugly, the structured credit market so counterparty driven, and the collapse of Lehman and AIG so dominant in the headlines, people often forget that the summer of 2008 saw a record spike in oil prices to a $145 per barrel WTI in early July 2008. That led to all kinds of draconian forecasts on SUVs and pickups. Used car values plunged and leases as a tool were suspended by numerous finance companies. What came after in the bank sector dwarfed oil as an issue, and the systemic crisis saw oil plunge as noted in the PCE decline in the chart.

The Saudi market share war of late 2014: The record shale oil production in the US elicited a response not unlike what was seen in the early 1980s when the North Sea, Alaska, the Gulf of Mexico, and US drilling ramped up supply. Production kicked back into gear, supply soared, and prices plunged to a bottom in Jan-Feb 2016. Financial stress in the US oil patch rose, and the US consumer got what was in substance a big tax cut in their energy and gasoline bills. Cost benefits along the goods and services supplier chain came with the plunge in both oil and natural gas.  PCE and Core PCE converged.

The COVID impact: During COVID, oil collapsed and deflation impacts on demand stress took over briefly. The dislocation between PCE and Core PCE was mild (0.5 point). PCE was below Core PCE on energy dislocations in April 2020 (reminder: the WTI contract was negative). The real story for PCE came with the snapback in demand in the face of shortages and then he Ukraine-Russia War in 2022.

For a better visual on the moves in more recent cycles, we add the chart above that starts in 1997. The stagflation years of the 1970s and early 1980s always distort the scale). The fall of 1997 saw credit spread lows in the markets ahead of the 1998 turbulence (Russia, EM, LTCM, etc.) and much worse TMT market turmoil to come later. The 2009 and 2015 oil plunges are outliers during periods of low inflation after the crisis. Dec 2015 marked the end of ZIRP, and July 2009 was the first month after the cyclical trough.

The above chart plots the differential between the PCE inflation and the Core PCE inflation numbers (PCE minus Core PCE). We clearly see a lot of negatives. The single line more clearly details the timing of the divergence between the two. In the end, the swings mostly come down to Energy and sometimes Food as we look back into the stagflation years. The idea that food inflation could spike higher into the 20% range is not without precedent, so the Ukraine-Russia threat to global supply and some severe summer weather patterns give the more bearish room to maneuver on scenarios.

The swings across time are clear enough and most can be tied to oil market turmoil and then relief. March 1974 was the month the Saudis and a few of the other majors ended the oil embargo (a few such as Libya kept it going). We see the stagflation period of March 1980 ahead of the peak Misery Index of June 1980 (see Misery Index: The Tracks of My Fears 10-6-22). November 1990 was the pre-war period of nerves in the oil market as troops were deployed to the Middle East (the fighting was over quickly in January 1991). The year 2000 saw a sharp rebound off the 1998-1999 lows in oil. July 2008 was the summer oil spike ahead of the fall financial crisis. Finally, the June 2022 marked the Russia-Ukraine side effects when the market saw the peak inflation rates for Energy YoY and also saw double digit inflation in Food.