The Fed’s Key Inflation Rate May Trip Up The S&P 500

This S&P 500 rally is built on belief that inflation will continue its steady retreat even as the U.S. economy avoids a hard landing. December’s CPI data seemed to bolster that view as services inflation excluding shelter dived to a tepid 1.2% annual rate in Q4. But the Fed focuses on the personal consumption expenditures price index, and new data out Thursday and Friday may show a much different story.

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PCE Inflation Rate Update

Investors will get quarterly PCE inflation data on Thursday at 8:30 a.m. ET, along with the Q4 GDP report. December inflation data will be broken out with Friday’s personal income and spending report.

Wall Street expects Friday’s data to show the PCE price index was flat in December, as the annual inflation rate slowed to 5% from 5.5%. Core PCE prices are seen rising 0.3%, as the core inflation rate slips to 4.4% from 4.7%.

However, Deutsche Bank economists warned that the last major inflation report before next week’s Fed meeting could bring unwelcome news. They’re predicting a 0.4% monthly rise in the core PCE price index, even though the core CPI rose a milder 0.3%.

Deutsche Bank’s economics team noted that the CPI report showed airfares falling 3.1% in December. Yet PCE price data for airfares comes from the producer price index, which showed a 3.1% increase last month.

PCE Vs. CPI Inflation

That difference only scratches the surface of huge differences between the CPI and PCE inflation reports. Those differences have become a big deal for the trajectory of both Fed policy and the S&P 500.

The PCE covers a much broader range of spending than the CPI, which only reflects out-of-pocket spending. The distinction is especially important when it comes to health care, since a huge share of medical bills get paid by employers, Medicaid and Medicare. While medical care services make up only 7% of the CPI’s basket of household purchases, health care services account for nearly 16% of PCE.

Not only that, but the CPI’s medical services inflation gauge began falling rapidly in October and that should continue since the source data relating to insurer profits is already in the books.

Powell’s new PCE services inflation measure also includes dining out, while food away from home isn’t included in the CPI’s services measure.

Fed Chair Powell’s Most Important Inflation Rate

In a Nov. 30 speech, Fed chair Jerome Powell acknowledged that goods inflation had cooled and leading indicators of housing inflation pointed to a sharp easing of rent pressures in 2023. But he highlighted a new area of concern for policymakers: core services inflation excluding housing.

The category, which includes health care, education, haircuts, hospitality and more, accounts for about 50% of consumption. Powell called it “the most important category for understanding the future evolution of core inflation.” That’s because price changes for such services are closely tied to wage growth. If the labor market remains extremely tight, high services inflation may persist.

The focus on core PCE services minus housing is so new that it isn’t provided in Commerce Department’s report or a subject of Wall Street estimates. IBD calculations show that the price index for PCE services minus housing and energy rose 0.3% on the month and 4.3% from a year ago, down from October’s upwardly revised 4.7% annual increase.

What Does This Mean For S&P 500?

The S&P 500 rally has paused the past two sessions, but stocks remain resilient. After falling as much as 1.7% in Wednesday morning’s stock market action, the S&P 500 bounced off its 50-day moving average, cutting its loss to just a fraction.

As of Tuesday’s close, the S&P 500 was 16.25% below its record closing high, but up 12.3% from its bear-market closing low on Oct. 12.

Be sure to read IBD’s The Big Picture each day to stay in sync with the market’s underlying trend and what it means for your trading decisions.

The S&P 500 is at a key juncture, trying to sustain a rally past its 50-day line, after the past few tries were quickly turned back. A hotter-than-expected core PCE inflation reading would come at a bad time, and may increase odds that the Fed will hike another 75 basis points to a range of 5%-5.25%. Currently, financial markets expect the Fed to pause after a quarter-point hike next Wednesday and another one on March 22.

Still, the real key to inflation and Fed policy is wage growth. December’s jobs report showed wage growth cooling to a 4% annual rate in Q4. If that moderation continues, the Fed will be more willing to wait and see, rather than hiking its benchmark rate past 5%. We’ll get two big reports on wage growth next week, with Tuesday’s Q4 Employment Cost Index and Friday’s January jobs report.

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