The core inflation rate, which the Fed normally monitors most closely, continued to decline in December. Still, Fed Chair Jerome Powell has recently put the focus on a new “key” inflation rate to make the case for further rate hikes: core PCE services less housing. The good news: Powell’s new favorite indicator slipped to 4.1% last month. The S&P 500, which ended Thursday’s rally, rose on Friday morning following the release of stock market data.
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The headline PCE (personal consumption expenditure) price index rose 0.1% for the month versus expectations of a flat reading. However, PCE inflation fell further to 5% from a 40-year high of 7% in June, in line with estimates. Core prices excluding food and energy rose 0.3% for the month as annual core inflation eased to 4.4%, as expected.
The Commerce Department’s personal income and spending data also showed that personal consumption spending fell 0.2%. Spending ended the year on a weak note, falling for two straight months. Adjusted for inflation, spending fell by 0.3%.
This rally in the S&P 500 is based at least in part on the belief that inflation will continue its steady decline even as the US economy avoids a hard landing. This suggests the Fed will pause rate hikes next Wednesday and March 22 after quarter point moves. Markets expect the Fed’s rate hikes to turn into rate cuts later this year.
Fed Chair Powell’s new inflation rate
This bullish scenario appeared to be supported by December’s PCE inflation data. That’s the case, though Powell has tried to shift focus to areas of the economy where he thinks inflation may prove most stubborn: non-energy PCE services and housing.
This category, which includes healthcare, education, haircuts, hospitality and more, accounts for about 50% of consumption. Powell has called it “the most important category for understanding the future path of core inflation”. This is because price changes for such services are closely linked to wage growth. If the labor market remains extremely tight, service inflation may remain high.
The focus on this statistic is so new that it is not included in either the Commerce Department report or Wall Street estimates. IBD calculations show that the price index for PCE services excluding housing and energy increased 0.3% mom and 4.1% yoy, compared to 4.3% in November.
Still, Powell’s new favorite inflation indicator has much further to fall. In contrast, the Labor Department’s December CPI data showed that inflation in non-housing services fell to an annualized rate of 1.2% in the fourth quarter.
This tepid CPI data grossly exaggerated the Fed’s progress on inflation control and underscored the vast disparities in the way the government measures PCE inflation and CPI inflation.
PCE vs. CPI inflation
The PCE covers a much broader spectrum of spending than the CPI, which only reflects out-of-pocket spending. The distinction is important, especially when it comes to healthcare. Employers and the government pay a large portion of medical bills, which the CPI ignores. While medical supplies account for only 7% of the CPI’s household purchases, health services make up nearly 16% of PCE.
Not only that, but in October the medical services CPI inflation gauge began falling rapidly. This drop should continue, but isn’t really indicative of current pricing. It reflects insurer earnings reported last fall.
Powell’s new inflation measure for PCE services includes restaurants, among numerous other differences. However, CPI data groups out-of-home groceries with goods, not services.
What does this mean for the S&P 500?
Continued inflation in Powell’s services category could keep Fed policy tighter for longer, but that’s far from clear. The real key to inflation and Fed policy is wage growth. The December jobs report showed wage growth slowing to an annual rate of 4% in the fourth quarter. That’s not too far above the 3.5% wage growth, which Powell said could be consistent with the Fed’s 2% inflation target.
If wage growth moderation continues, the Fed can be more patient in waiting for inflation to ease. Two reports on next week’s wage growth stand out: Tuesday’s fourth-quarter employment cost index and Friday’s January jobs report.
Meanwhile, the S&P 500 remained in rally mode, up 0.4% on Friday. The benchmark is now up to its highest level since December 13, trading just a fraction below the 4,100 level. There, the December rally was reversed.
As of Thursday’s close, the S&P 500 was down 15.35% from its record closing high, but was up 13.5% from its Oct. 12 bear market closing low.
Be sure to read IBD’s The Big Picture every day to keep up to date with the underlying trend of the market and what it means to your trading decisions.
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