Is the US inflation genie at risk of escaping its bottle again?

Yesterday’s PCE inflation report, published by the Bureau of Economic Analysis, was probably more keenly awaited by the markets than is usual. The PCE number (specifically the core reading ex rents, which excludes food and energy prices and shelter costs) is the Fed’s preferred measure of inflation and, with the January CPI report printing above expectations, fears were elevated regarding whether that message of stronger inflationary forces would be repeated in the PCE numbers yesterday and, if so, what reaction this might potentially trigger from the Fed.

Ultimately core PCE inflation was reported in January at 0.42%, the highest reading since February 2023 and, on its own, inconsistent with the Fed’s 2% inflation target – to achieve an annual sustained inflation reading of 2% a consistent monthly reading of between 0.1% and 0.2% is required. Surprisingly, the reaction of the market to the release was to breathe a collective sigh of relief, principally as the number was largely in line with expectations. However, on its own, a 0.42% monthly print translates to an annual inflation rate of approximately 5%; it is difficult, therefore, to conclude that yesterday’s number was anything other than ‘hot’. Furthermore, the 0.42% reading largely matched the 0.4% core CPI reading for January, and when reading both figures in conjunction with each other legitimately raises the question of whether the disinflation we had been seeing in the US is starting to stall - and if a renewed acceleration in inflation is emerging.

On an annual basis, core PCE fell, slipping from 2.9% to 2.84%. However, a significant factor behind this weakening can be attributed to favourable base effects, temporary factors that leave the annual print at risk of starting to rise again should the monthly number continue to print above 0.2%. A further worry for the Fed will also be the breakdown in the PCE numbers. The post-pandemic fall in overall goods prices is continuing to be seen, albeit with signs that this is starting to now ease (durable goods prices actually rose by 0.2% in January). But more concerning for the Fed will be the stickiness being seen in the price of services, a sector accounting for nearly 80% of US GDP and which rose by 0.6% in January, the highest monthly rise for one year. Rising services prices, alongside signals that goods prices may also be starting to increase, are likely to set some alarm bells ringing somewhere.

However, the market is clearly not panicking yet, and there are good reasons to support this sanguinity. Firstly, as we reported yesterday, the January jump in owner-equivalent events, following the re-weighting of single-family homes in its calculation, will boost both CPI and PCE over H1 this year and is a statistical anomaly rather than anything more sinister (https://www.equiti.com/sc-en/news/global-macro-analysis/has-the-us-bureau-of-labour-statistics-given-the-fed-a-reason-to-delay-monetary-easing/). Second, yesterday’s 0.42% number also needs to be read in the context of the monthly readings seen over the previous three months (0.15%, 0.09% and 0.14%), suggesting yesterday’s reading contained an element of correction. And thirdly, the start of the year also saw a rise in financial services costs, largely the result of the strength currently being seen in equity prices, and which will not likely be repeated. And finally of course, one month’s data is insufficient in itself to suggest an observed underlying trend has necessarily reversed.

Accordingly, judging by its reaction yesterday, the market is still taking the bigger picture view that inflationary pressures will continue to soften going forward as the pass-through from improving supply chains, margin re-compression and slowing wages gains feed through into the real economy. However, after getting the ‘transitory’ inflation argument so wrong, the Fed remains ultra-cautious to any signs that deflationary pressures may be easing, and the stronger inflation reports we have seen for January may be enough to persuade the ‘hawks’ on the FOMC that any interest rate cuts should be delayed until at least H2, ‘just in case’. But if February delivers a set of similarly stronger numbers then we may well see a panicking Fed increasingly signal concerns that the inflation genie is possibly escaping its bottle again.