Preview of this week’s US PCE Deflator number

Friday delivers the PCE deflator reading for the US, the measure of inflation preferred by the Fed.  In itself the number is not really all that useful, as coming after the monthly CPI and PPI releases it does not contain much additional useful information for the markets.  Its release normally therefore passes somewhat quietly.  However, these days things are slightly different, given that the PCE deflator is the stated preferred measure of inflationary pressure used by the Fed.  And with this in mind, this week’s number has the potential to be market moving. 

The PCE deflator is a very close analogue of the PPI numbers, ie they are both whole economy output price measures.  This means the unexpected rise seen in the monthly PPI numbers last week almost certainly means we will see a similar bounce in the PCE deflator number on Friday too.  Given the size of the jump in the PPI numbers, it is entirely possible that we could see the annual PCE deflator show a similar jump to move back above the 5% level on a annualised monthly basis, an outcome that may well trigger a worried response from the Fed and entrench fears that inflationary pressures are becoming increasingly ‘sticky’ and once again on the rise.

The suggestion that the decline seen so far in inflation might be stalling is all the more worrying given the improvements being seen in the supply side of the economy and the impact of favourable base effects.  These would be expected to be exerting downwards pressure on inflation.  If, in contrast, the PCE report points to a resilience in domestic demand (possibly driven by on-going recourse being made to excess savings stocks) and a loosening in financial markets conditions seen over Q4/Q1 as being drivers behind this renewed inflationary pressure, then this would suggest there are growing and significant headwinds to the Fed’s demand dampening efforts.  Such a scenario may well see the Fed re-assess its expected peak fed funds rate and cause it to pivot in favour of a more hawkish position.  The December dot plot currently shows an expected peak fed funds rates of 5.25%;  but with a rate as high as 5.75% also suggested.

The caveat to all of this is the warm weather seen over the month of January, a phenomenon that is already been blamed for the stronger payrolls, CPI and PPI numbers seen for the month.  This warmer weather probably allowed US consumers to venture out more to take advantage of the increased leisure and hospitality opportunities made available to them.  In a similar fashion, the surge seen in items such as used vehicle prices was similarly the result of buyers encouraged to visit car lots.  These things will prove temporary and should drop out of the data next month.

For Friday’s release, therefore, the key issue is probably how strong any resilience in demand is reported as being and whether the market determines there is more behind it than just a brief spell of above-average temperatures.  If the outcome is to ignore the weather and conclude that the Fed needs to do more to reduce aggregate demand, then expectations of the peak fed funds rate will almost certainly rise.  Friday afternoon could be a difficult one for the equity markets but a positive one for the US dollar.