Fed caution aligned with inflation internals, core PCE likely to be sticky

The Federal Reserve's latest meeting minutes underscored a cautious approach towards reducing interest rates too quickly, especially given the persisting tightness in the labour market and the yet-to-be-confirmed indications that inflation is on a consistent downward trajectory. This careful stance seems well justified when examining the internals of inflation and their alignment with the Fed's perspective.

Delving into inflation internals

By leveraging insights from Indicio and considering various factors, the US Core Personal Consumption Expenditures (PCE) Price Index for January 2024 is projected at 2.85%, slightly down from 2.9% in December 2023. However, the month-over-month increase is estimated at around 0.4%, higher than the 0.2% rise observed in December. This nuanced analysis sheds light on the intricate dynamics influencing inflation.

Various measures of core PCE and its composition

In December, Goods PCE was almost at 0, while Services PCE surged to 3.91%, pushing the overall core PCE to 2.9%. Other measures, such as the Cleveland Fed median inflation at 3.8%, the Trimmed mean 12-month at 3.3%, and the BEA’s market-based PCE at 2.95%, all hover above the Fed's 2% target. This suggests that, despite the slight decline, inflation pressures remain.

Expenditure and price decline dynamics

The discrepancy between the share of expenditure with price declines in PCE at 15% and the fraction of declining items in PCE at 35% highlights the stickiness in core inflation and the challenges in steering it towards the target.‍

Cyclicality of inflation trends

The disparity between cyclical inflation at 5.4% and non-cyclical inflation at 1.5% in December underscores the dominant contribution of recent cyclical factors to the core PCE of 2.9%. Factors such as robust growth momentum, tight labour market conditions, and resilient consumer spending have exacerbated the cyclical component of inflation.

Supply and demand driven inflation factors

Initially spurred by a supply shock, the inflationary cycle quickly transitioned into a demand-driven inflation phase, fuelled by substantial fiscal spending post-Covid. As supply chain disruptions began to ease, it became evident that demand-driven factors, evident in ‘Services’ inflation would need to be moderated to achieve the Fed's 2% inflation target.

Core PCE forecast for January 2024

Using a variety of indicators related to economic growth, labour market dynamics, earnings, government spending and the real estate sector, Indicio employs multivariate models to forecast Core PCE. Adjustments and transformations facilitated by Indicio allow for rapid estimation through multiple models. The analysis points to earnings growth as a significant driver of Core PCE, with month-on-month momentum expected to rise to 0.4% from the previous month's 0.2%. The forecasted year-over-year core PCE of 2.85% for January remains elevated, indicating ongoing inflationary pressures.

In conclusion, the Fed’s caution in adjusting interest rates is well-founded, with inflation internals suggesting a complex interplay of factors that require careful monitoring and management. The analysis underscores the challenges in achieving and maintaining the Fed's inflation target, highlighting the need for a nuanced approach to monetary policy.