The core inflation rate, which the central bank usually watches more closely, eased further in December. Yet Fed Chairman Jerome Powell has recently focused on a new “most important” measure of inflation that makes the case for continued rate hikes: core PCE services less housing. The good news: Powell’s new preferred indicator fell 4.1% last month. The S&P 500 was slightly lower on Friday morning, coming off Thursday’s rally Stock market activity After the release of the data.
The overall PCE (personal consumption expenditures) price index rose 0.1%. However, the PCE inflation rate continued to ease from June’s 40-year high of 7%, falling to 5% according to estimates. Core prices, excluding food and energy, rose 0.3% in the month, as the annual core inflation rate eased to an expected 4.4%.
Per capita income and expenditure data also showed that per capita consumption expenditure fell by 0.2%. Spending ended the year on a softer note, falling for two consecutive months. Adjusted for inflation, spending fell by 0.3%.
The S&P 500 rally has been built on hopes that inflation will continue its steady retreat even as the US economy avoids a hard landing. This suggests the central bank may hold off on a rate hike next Wednesday and after quarterly point moves on March 22. Markets expect central bank rate hikes to turn into rate cuts later this year.
Fed Chair Powell’s New Inflation Rate
That bullish scenario seemed to get support from December’s PCE inflation data. That’s the case even if Powell tries to focus on the areas of the economy where he thinks inflation will be more stable: PCE services excluding energy and housing.
That category, which includes healthcare, education, hairdressing, hospitality and more, accounts for about 50% of consumption. Powell called it “the most important category for understanding the future evolution of core inflation.” This is because price changes for such services are closely linked to wage growth. If the labor market is too tight, high service inflation may persist.
The focus on this statistic is so new that it has not been reported in the Commerce Department’s report or in Wall Street’s valuation material. IBD calculations showed the PCE price index for services, excluding housing and energy, rose 0.3% in the month and 4.1% a year ago, down from 4.3% in November.
However, Powell’s new preferred inflation indicator may not fall as fast as some had hoped. When the CPI data came out on January 12, many analysts pointed to Powell’s focus on inflation in services excluding accommodation as good news. That CPI measure showed prices in this category fell at a modest 1.2% annualized rate in Q4.
Yet it underscores the big differences in the way the government measures PCE inflation and CPI inflation.
PCE Vs. CPI inflation
PCE covers a wider range of spending than CPI, which only reflects out-of-pocket spending. The distinction 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 medical care services account for only 7% of CPI’s household purchases, health services account for nearly 16% of PCE.
Not only that, the CPI’s medical services inflation rate started to fall sharply in October. That drop should continue, but that’s not really the case with current pricing. This mirrors the insurer’s profit reported last fall.
Among many other differences, Powell’s new PCE services inflation measure includes food intake. However, the CPI data groups food from home with goods, not services.
What does this mean for the S&P 500?
Steady inflation in Powell’s services sector may keep Fed policy tighter longer, but that’s far from clear. The real key to inflation and central bank policy is wage growth. December’s jobs report showed wage growth cooled to a 4% annualized rate in Q4. That’s not far off the 3.5% wage growth that Powell said would be consistent with the Fed’s 2% inflation target.
If wage growth continues to moderate, the central bank can be more patient until inflation eases. There are two big reports on wage growth next week: Tuesday’s Q4 employment cost index and Friday’s January jobs report.
Meanwhile, the S&P 500 has Stayed in rally mode, despite falling 0.2% early Friday. The benchmark has now fallen to its highest level since December 13 and is trading just a fraction below the 4,100 mark. This is an important junction. The S&P 500’s recent attempts to hold the 4,100 level were soon withdrawn.
As of Thursday’s close, the S&P 500 was 15.35% below its record high, but 13.5% above its peer-market low on Oct. 12.
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