This Week’s Developments in the US Economy
The Expected Rate Path and the Balance of Risks Are Coming into Focus
Where is PCE headed and how might it impact the Fed’s decision-making?
The Fed continues to navigate a complex balancing act as they work toward achieving their dual mandate of price stability and maximum employment. Last week, Headline Personal Consumption Expenditures (“PCE”) inflation registered an expected uptick from 2.4% to 2.5% in the February reading. Core PCE on the other hand, a measure closely watched by the Fed, inched closer to the 2% target as it declined to 2.8% with the prior reading revised upward. This week, we expect the US jobs report will post another strong report after early indications from private sector payroll provider ADP—so the maximum employment mandate appears to be stable for now. As for the sustained path to 2% that the Fed seeks, a mix of indicators suggests the balance of risks may lead to 2% eventually, but a strong economy has several Fed members still in holding position.
While Fed Chair Powell has conveyed that cutting rates is not far off, the Federal Open Market Committee (“FOMC”) needs more confidence that inflation is on a sustainable path towards 2% before easing monetary policy. As mentioned in a recent note, the last Summary of Economic Projections (“SEP”), the projected policy path had at year-end nine members in the two-or-fewer cuts camp and ten in the three-or-more camp. While there is one more PCE release before the next Fed meeting, the market is pricing in a less than 10% likelihood of a cut on May 1st, a view aligned with Fed official Loretta Mester’s position against a rate cut at the next meeting. While certain Fed officials have emphasized the possibility and potential necessity of holding rates for longer, Fed official Mary Daly recently warned of the downside economic risks involved.
This week, we explore components of PCE that could function as headwinds and prolong the journey toward the Fed’s 2% target. While inflation has been on a gradual decline, it is important to be aware of the potential headwinds which not only might contribute to an extended Fed hold but also could lead to a resurgence of inflation.
Rising Oil Prices Exert Upward Pressure on Inflation
One potential headwind for inflation is recent growth in oil prices exerting upward pressure on energy prices. While core inflation readings strip out energy and food prices, energy costs are still inputs for transportation and production. On a month-over-month basis, Headline PCE grew by 0.3%, partly attributed to a notable 2.3% increase in energy prices. Gasoline and other motor fuels experienced a significant surge to 3.7% month-over-month in February, following four consecutive months of negative figures and a decline of -3.3% in January. Going forward, energy inflation could see further upward pressure from rising oil prices. The recent uptick in Brent Crude (up nearly 20% YTD) may persist due to escalating geopolitical tensions and a recently announced continuation of production cuts by OPEC+. If oil prices climb, so may energy costs, impacting transportation and production expenses. This could translate into price pressures on consumer goods and other products, with the knock-on effects contributing to upward pressure on overall inflation figures.
Components within Services See Increased Inflation Figures
Another potential headwind is persistent price growth within major components of PCE. While Core PCE continued its downward trend, decreasing by ten basis points to 2.8%. Of this, 2.75% was attributed to services, with the three largest contributors in housing and utilities (1.1%), healthcare (0.6%), and financial services and insurance (0.3%). As these components are largely contract-based, they generally operate at a lag, potentially resulting in current conditions not being fully reflected in the numbers. While the housing component has been on a declining trajectory, financial services, insurance, healthcare have seen prices continue to rise.
When looking at the health care sector, a labor-intensive industry, we continue to see high wage growth. In January, the sector posted 3.5% year-over-year growth in average hourly earnings, well above the post-GFC average of 2.4%. Given that health care services have a considerable weight in PCE vs. CPI (16.1% vs. 6.5%, respectively), this sector is a key area to watch.
