PCE Report: The “Inflation Bump” Just Got Bigger (SP500)

The February PCE inflation report

The US Bureau of Labor released the February PCE inflation data. The highlights are:

• the core PCE inflation increased by 0.3% MoM, as expected, and 2.8% YoY also as expected, down from 2.9% in January – so technically the disinflationary process continues.
• the headline PCE inflation also increased by 0.3% MoM, which is below the 0.4% consensus expectations, and 2.5% YoY as expected, but that’s higher compared to the January reading of 2.4% – thus the headline PCE inflation is on the rise.
• However, it is important to point out that there were significant revisions to the January PCE inflation readings.
  • the core PCE inflation for January was revised higher from 0.4% MoM to 0.5% MoM.
  • the headline PCE inflation was also revised higher from 0.3% MoM to 0.4% MoM.

So, what are the implications of the February PCE inflation data?

First of all, the February PCE inflation data confirms the February CPI inflation data. Both inflation readings are still well above the Fed’s target of 0.1-0.2% monthly inflation, and indicate that the January “spike” is not just a seasonal issue.

The macro context

The Fed has stated that the increase in the monthly CPI and PCE inflation in January and February is just “a bump” on the way to the 2% inflation target over time.

Thus, the Fed’s view is that it should not overreact to the recently “hot” inflation readings. More importantly, the Fed stated that it is still on track to cut interest rates three times in 2024 – despite the current “inflationary bump”.

Obviously, the Fed anticipates that the monthly inflation readings will return to the 0.1-0.2% range, which is consistent with the 2% annual target. Note, a 0.3% monthly inflation is consistent with the 3.5% annual inflation, and that’s should be unacceptably high if it remains consistent.

The Fed currently needs to see more evidence to get the “greater confidence” that inflation is on the sustainable path to the 2% inflation target over time – before actually starting to cut interest rates, as signaled in the march SEP dop-plot.

Note, the Fed’s preferred inflation metric is the core PCE inflation, which is generally 0.5% higher on an annual basis than the core CPI inflation. That’s why the PCE inflation report is more important than the CPI inflation report – although the CPI report is released earlier in the month, and thus provides the clue about the PCE inflation data.

So, what did the Fed learn from the February PCE report?

The “inflation bump” got bigger

The revision to the January core PCE inflation is significant – the core PCE inflation in January spiked by 0.5% (revised from 0.4%), and that is around 6% annualized. Thus, the inflation bump got bigger.

More importantly, if the January core PCE inflation spike was one-off, the February core PCE would be much lower. The fact that the February core PCE came at 0.3% signals that inflationary pressures are building.

Here is the chart of the core PCE month over month.

What’s driving the “inflationary bump”?

• First, the price of goods spiked by 0.5% in February, after decreasing by 0.2% in January. More specifically, the price of non-durable goods spiked by 0.7% in February.
• More importantly, the price of durable goods increased by 0.2% in February, which matches the 0.2% increase in January. This follows six months of falling durable goods prices. The disinflationary process has been progressing mainly due to the falling durable goods prices as the post-pandemic supply chain disruptions eased. However, over the last two months, the prices of durable goods have been rising – and this suggests that the deflationary effect of durable goods prices has ended.
• The service inflation increased by 0.3% MoM in February, which is less than 0.6% spike in January – and this is what caused the core PCE reading in February to drop below 0.5% spike in January. However, given the strong labor market, it is reasonable to expect a pickup in service inflation over the next few months.
• Thus, it is very unlikely that the January spike in inflation is just a “bump”, the durable goods prices are rising, and service inflation is still a problem due to a strong labor market.

Here is the BLS table with PCE inflation data;

Implications

The February PCE inflation data confirms that the inflationary pressures are building and that the January inflation spike is even more serious. Durable goods prices have been rising now for two months, and this trend is likely to continue. The service prices are also likely to stay elevated due to the strong labor market.

The Fed cannot get any confidence from the February PCE inflation data that inflation is falling to the 2% target. On the contrary, it appears that the inflation pressures are building.

Thus, based on the evidence so far in 2024, the Fed is not going to be able to cut interest rates in June, as the market currently expects.

It is more likely that the Fed will eventually cut interest rates in response to the weakening labor market and a recession. When will the recession hit? The longer the yield curve stays inverted, the higher the recession probability, and we have a record long yield curve inversion currently. The first sign of a recession will likely be the spike in the weekly claims for unemployment, and we are not there yet. Some think the recession will hit after the elections in November.

The S&P500 (SP500) has been rising since the Fed’s dovish turn in November. The February PCE inflation report is unlikely to cause the selloff, since it only confirms the February CPI inflation data.

Thus, the next trigger for a significant correction in S&P500 will be the CPI report for March. If it confirms that the inflationary pressures are building and rejects the inflation bump thesis, the correction could be significant. Until then, my rating for S&P500 is still a Hold.