New data released along with the GDP figures on Thursday showed that the Fed’s preferred rate of inflation, which is a core personal consumption expenditures price indicator, eased to a 3.85% annualized rate in the fourth quarter. While the monthly PCE inflation data released on Friday at 8:30 AM ET will come under further scrutiny, easing in core prices on a quarterly basis indicates that there are no major unwanted surprises awaiting. That helped lift the S&P 500 to its highest level since the last Federal Reserve meeting on Thursday The work of the stock market.
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Wall Street expects data on Friday to show that the personal consumption expenditures price index was flat in December, as the annual rate of inflation slowed to 5% from 5.5%. Core PCE prices are expected to rise 0.3%, as core inflation fell to 4.4% from 4.7%.
The rally for the S&P 500 was built on the belief that inflation will continue its steady decline even as the US economy avoids a hard landing. That could allow the Fed to pause interest rate hikes after quarter-point moves next Wednesday and on March 22. Markets expect the Fed rate hike to turn into rate cuts later this year.
Fed Chairman Powell’s new inflation rate
This bullish scenario appears to be supported by the fourth quarter inflation data of PCE. However, it may be too early to celebrate. That’s because Fed Chairman Jerome Powell has tried to shift the focus of policymakers and investors to a new key inflation rate: personal consumption expenditures excluding energy and housing.
This category, which includes healthcare, education, hair cutting, hospitality and more, accounts for about 50% of consumption. Powell called it “the most important category for understanding the future development of core inflation.” This is because price changes for these services are closely related to wage growth. If the labor market remains very tight, high service inflation could persist.
So what did the Q4 PCE data show? The news wasn’t great: The core personal consumption expenditures price index minus housing rose at a 4.7% annual rate in the fourth quarter. Inflation for core personal consumption expenditures services minus housing rose over the past 12 months to 4.4% from 4.2%.
The data may come as a bit of a surprise. When the CPI data came out on January 12, a number of analysts pointed to good news for Powell’s focus on inflation in services excluding shelter. A measure of the Consumer Price Index showed that prices in this category eased to a tepid annualized rate of 1.2% in the fourth quarter.
However, it underscores the huge differences in the way the government measures PCE inflation and CPI inflation.
PCE vs. Consumer price index inflation
PCE covers a much wider range of spending than the CPI, which only reflects out-of-pocket spending. Discrimination is important, especially when it comes to health care. Employers and the government pay a large share of medical bills, which the CPI ignores. While Medicare services make up only 7% of the CPI household basket, healthcare services account for nearly 16% of personal consumption expenditures.
Not only that, but a measure of the CPI’s medical services inflation began to fall rapidly in October. This decline should continue, but it is not really indicative of current prices. It reflects the insurance company’s reported earnings last fall.
Among many other differences, Powell’s new PCE services inflation measure also includes eating out. However, the CPI data groups food away from home with goods, not services.
What does this mean for the S&P 500?
If Powell’s “most important” inflation rate continues to rise in the fourth quarter, why is the S&P 500 soaring?
Partly that may be due to earnings, though Tesla (TSLA) get a prominent pop. It’s also possible that investors don’t care much about Powell’s new inflation class.
The focus on core personal consumption expenditures minus housing is so new that it was not made available in the Commerce Department’s report or the subject matter of Wall Street’s estimates. The IBD calculations to derive the quarterly data in this article and the monthly data in the accompanying graph require a multi-step process.
Continued inflation in Powell’s service class could keep the Fed’s policy tightening for a while longer, but that is far from clear. The real key to inflation and Fed policy is wage growth. The December jobs report showed wage growth slowing to a 4% annual rate in the fourth quarter. That’s not much higher than the 3.5% wage growth that Powell said could be consistent with the federal inflation target of 2%.
If wage growth continues to moderate, the Fed can be more patient in waiting for inflation to ease. There are two big reports on wage growth next week looming: the Employment Cost Index for the fourth quarter on Tuesday and the January jobs report on Friday.
Meanwhile, the S&P 500 remains in bullish mode, up 0.6% in Thursday afternoon trading. After trading on either side of the 200-day line for the past two weeks, the S&P 500 has now climbed to its highest level since Dec. 14. This is a major turning point. The S&P500’s last few attempts to break away from the 200-day line quickly fell back.
As of Wednesday’s close, the S&P 500 was 16.3% below its record closing high, but up 12.3% from its October 12 bear market closing low.
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