Fed’s Preferred Inflation Measure Supports Further Rate Hikes

The Fed’s concern that inflation won’t decline as rapidly as some hoped was evident in January’s Personal Consumption Expenditures inflation data. Prices rose 0.6% month-on-month for January, the largest monthly increase since June 2022. On an annual basis prices rose 5.4%, a slight increase from December.

The increases in prices was relatively broad with both goods and services rising by the same 0.6% amount on a month-on-month basis. Stripping out food and energy also resulted in a 0.6% increase, as energy prices rose 2% for the month, though food prices rose 0.4%, a slower rate than past months. This was slightly ahead of the 0.5% increase reported in CPI inflation for January, which uses different approaches to measure inflation.

A Problem For The Fed

This presents a problem for the narrative that inflation is under control and returning to 2% because monthly increases of 0.6% translate to over 7% annual inflation. That said, this is a single month of data and inflation has been more subdued since last summer.

Market Expectations

Some of these concerns have been reflected in fixed income markets in recent weeks. Markets currently expect the rate to continue to raise rates at future meetings, perhaps until June, so this higher inflation news may not cause an abrupt change in the Fed’s policy actions. However, the minutes from the Fed’s February meeting did suggest that certain policymakers would have been comfortable with a 0.5-percentage-point move up in rates, in contrast to the 0.25-percentage-point increase the Fed implemented, so there is some chance the Fed contemplates larger rate moves if inflation data continues to be concerning.

Incoming Data

Nowcasts from the Cleveland Fed, which look at current price trends to estimate upcoming inflation releases suggests that February inflation may remain relatively elevated. Current estimates call for 0.45% core monthly CPI inflation and 0.38% core CPE inflation for the month of February. If that holds it’s consistent with the narrative that inflation has peaked, but also that inflation isn’t returning to 2%, the Fed’s annual target, as quickly as the Fed would like.

However, a big question mark is housing. House prices in the U.S. appears to be set to turn in 2023, in part due to the Fed’s actions. If that happens, it could help bring down inflation, but we’re not seeing that in the data yet, part of the reason is statistical. Still the Fed will be concerned that even if house prices moderate, other services prices may remain stubbornly high. That’s in part because the job market remains strong, pushing up wage costs.

The January PCE inflation release was broadly consistent with CPI inflation from earlier in the month and fixed income markets are already moving to price in the Fed raising rates for longer at upcoming meetings. However, the data serves as a reminder of the Fed’s concern that inflation may not return to 2% as quickly as hoped.