Fed’s new key inflation rate fell in December; S&P 500 Tie

The core inflation rate, which the Fed has typically watched closely, eased further in December. Still, Fed Chair Jerome Powell has recently focused on a new “key” inflation rate to argue for continued rate hikes: core PCE services less housing. The good news: Powell’s new favorite indicator fell to 4.1% last month. The S&P 500, coming off Thursday’s rally, remained slightly lower in the stock market on Friday morning after the release of the data.

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The overall PCE (personal consumption expenditure) price index rose 0.1% month-on-month compared with expectations for a flat reading. However, the PCE inflation rate continued to ease from June’s 40-year high of 7%, falling to 5%, in line with estimates. Core prices, minus food and energy, rose 0.3% on the month as annual core inflation fell to 4.4%, as expected.

The personal income and consumption data also showed that personal consumption expenditure fell 0.2%. Spending ended the year on a soft note, falling for two consecutive months. Adjusted for inflation, expenditure fell by 0.3 per cent.

This S&P 500 rally is at least partly built on the belief that inflation will continue its steady retreat even if the US economy avoids a hard landing. It suggests that the Fed will stop raising interest rates after quarter-point movements next Wednesday and 22 March. Markets expect Fed rate hikes to transition to rate cuts late this year.

Fed Chair Powell’s New Inflation Rate

The bullish scenario appeared to be supported by December’s PCE inflation data. That’s the case even though Powell has tried to shift focus to areas of the economy where he thinks inflation could prove most persistent: PCE services excluding energy and housing.

This category, which includes healthcare, education, haircuts, hospitality and more, accounts for about 50% of spending. Powell has called it “the most important category for understanding the future evolution of core inflation.” This is because price changes for such services are closely linked to wage growth. If the labor market remains extremely tight, high service inflation may persist.

The focus on this statistic is so new that it is not given in the Commerce Department’s report or a subject of Wall Street estimates. IBD calculations show the price index for PCE services minus housing and energy rose 0.3% on the month and 4.1% from a year ago, down from 4.3% in November.

Still, Powell’s new favorite inflation indicator may not fall as quickly as some might have expected. When CPI data came out on January 12, a number of analysts pointed to good news for Powell’s focus on non-shelter services inflation. This CPI measure showed that prices in this category declined at a tepid 1.2% annual rate in the 4th quarter.

Still, it underscores the vast differences in the way the government measures PCE inflation and CPI inflation.

PCE vs. CPI inflation

PCE covers a much wider range of expenditure than CPI, which only reflects out-of-pocket expenditure. 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 services make up only 7% of the CPI’s basket of household purchases, healthcare accounts for nearly 16% of PCE.

Not only that, but the CPI’s gauge of inflation for medical services began to fall rapidly in October. That drop should continue, but it’s not really indicative of current prices. It reflects the insurance company’s profit reported last autumn.

Among many other differences, Powell’s new inflation target for PCE services also includes eating out. However, CPI data groups food from home with goods, not services.

What does this mean for the S&P 500?

Persistent inflation in Powell’s service category may keep Fed policy tighter for longer, but it is far from certain. The real key to inflation and Fed policy is wage growth. December’s jobs report showed that wage growth slowed to an annual rate of 4% in the 4th quarter. That’s not that far above the 3.5% wage growth that Powell has said could be consistent with the Fed’s 2% inflation target.

If the moderation in wage growth continues, the Fed may be more patient in waiting for inflation to subside. Two reports on wage growth next week loom: Tuesday’s Q4 Employment Cost Index and Friday’s January jobs report.

Meanwhile, the S&P 500 has remained in rally mode, despite falling 0.2% early Friday. The benchmark index has now pushed to its highest level since December 13, and is trading just a fraction below the 4,100 mark. This is a key point. The S&P 500’s last attempt to take and hold the 4,100 level was quickly reversed.

At Thursday’s close, the S&P 500 was 15.35% below its record high, but up 13.5% from the bottom of the Oct. 12 bear market.

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

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