US December PCE numbers point to inflationary pressures continuing to weaken

Today’s latest set of pricing data from the US showed core PCE, the measure of inflation targeted by the Fed, falling to 2.9% on an annual basis in December, the lowest reading since March 2021. On a monthly basis the index rose by 0.20%, which when combined with the small revisions made to the October and November prints, brings today's number in line with the quarterly core PCE price index number released yesterday, which rose by 2.0% on a quarterly basis to match the Q3 reading and pointing to the Federal Reserve (Fed) having reached its inflation target for two consecutive quarters. Today's annual reading of 2.9% clearly remains above target, but much of this is accounted for by the rapid increases seen in core prices over H1 which will now start to drop out of the numbers going forward, allowing the annual rate to fall back again.

Within the figures, core services prices ex rents rose by 0.28%, the fastest pace of growth for three months and something that will be disappointing for the Fed, particularly so given its excessive focus on this inflation measure. However, the annualized rate of growth over Q4 was 2.6%, the slowest pace of growth for some three years and continuing the move back towards the general 2% annual increases that were the norm pre-Covid. Key to how much faster – or indeed whether – this metric will move lower will likely be dependent upon how far and fast the pace of increase being seen in wages growth slows, given that labour costs are typically the single most important cost component for firms operating in the services sector.

More encouragingly, core goods prices moved in the opposite direction, falling by 0.27%, to leave the annual rate of growth at just over zero. Overall, the picture being painted is one of inflationary pressures remaining contained and on a path to soften further going forward.

However, whether or not this translates into interest rate cuts being seen any time soon remains more of a moot point. Today’s strong personal spending number – 0.7% for December – is likely to continue to worry the more hawkish members of the FOMC who continue to fret over the possibility of a strong labour market pushing inflationary pressures higher, or at best preventing them from falling much lower. And it is easy to have some sympathy with this view. Although the boost to spending seen over 2022 and much of last year from the excess savings built up during the Covid pandemic has now largely faded, spending patterns are instead finding support from rising incomes, which are estimated to have risen on an annualised rate over Q4 by approximately 2.5% on a real basis. And this growth in real incomes is expected to be maintained as robust demand for labour keeps wages growth above trend and inflation continues to fall.

The Fed will also be concerned that cutting interest rates also threatens to reignite inflationary pressures, in particular via the housing sector, where any easing in financial market conditions can be expected to reignite what is very much a stagnant housing market and triggering a concomitant increase in housing-related spending.

Overall, today’s numbers should see the Fed lower its forecasts for inflation when it releases updated projections in March, something that would provide it with the hook to potentially cut rates at that meeting if it chose to do so. However, in light of yesterday’s strong growth numbers, a still strong labour market, and an annual rate of core CPI of 3.9%, we expect the FOMC to defer at that meeting and push a first rate cut back to at least May. And even then, any easing in monetary policy is likely to be a slow and drawn-out process.