The Federal Reserve’s most important inflation rate, due for an August update on Friday morning, is forecast to undercut 4% and may fall as low as 2.5% on a 3-month annualized basis. That could help arrest the S&P 500 slide and defuse the creeping sense of doom on Wall Street as the 10-year Treasury yield and other market interest rates have surged since the Fed took a hawkish turn in policy last Wednesday.
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Core PCE Inflation
Economists expect the personal consumption expenditures, or PCE, price index to rise 0.5% from July amid a jump in gas prices. That would lift the 12-month PCE inflation rate to 3.5% from 3.3% the prior month.
Yet Federal Reserve decision-making puts more weight on core inflation, which strips out volatile food and energy prices. The good news is that the Fed’s favorite inflation gauge, the core PCE price index, is expected to show a modest 0.2% increase for August. The 12-month core inflation rate should slip to 3.9%, the lowest level since September 2021, from 4.2% in July.
Federal Reserve Policy Implications
Fed chair Jerome Powell, in his news conference last Wednesday, already acknowledged “three straight good inflation reports” for June, July and August. Data from the consumer price index and producer price index that feeds into the PCE price index pretty much assures only a modest rise on Friday.
If Friday’s inflation report comes in as expected, the 3-month annualized core PCE inflation rate would fall to just 2.5% from 3.1% in July.
However, Powell said the Fed wants to see six months of tame inflation data before policymakers will gain confidence in the current trend. We’re not there yet, but we could be getting close. The 6-month annualized core PCE inflation rate eased to 3.4% in July and could slip to 3.1% in August.
That suggests the Dec. 12-13 Fed meeting may be when the Fed finally begins to let down its guard against inflation and signals lower rates ahead.
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Supercore Inflation
Starting late last year, Federal Reserve chair Powell shifted the inflation focus to core PCE services excluding housing, or supercore services. That’s in keeping with the Fed’s view that the tight labor market and elevated wage growth have been at the root of stubbornly high inflation. Wages make up a high percentage of costs for service businesses. Therefore, supercore services inflation should ease as wage pressures moderate.
July PCE data for these services, such as health care, haircuts and hospitality, showed prices jumping nearly 0.5% for a second straight month. Over the past three months, supercore services inflation has run at a 3.85% annualized pace, up from 3.2% in June. The annual inflation rate picked up to 4.7% from 4.1%.
But July’s data overstates inflation pressures. That’s because half of the monthly increase came from portfolio management prices, which jumped 7.3% from June as the S&P 500 continued to rally. That effect could begin to reverse in August, after stock prices peaked in late July.
The Fed Is Wrong
The Fed is acting like U.S. consumers are unstoppable, but they may already be running out of gas. The new projections extrapolate strong consumer spending in June and July, even as Powell acknowledged that pressures on household finances have escalated quite suddenly.
The resumption of federal student loan payments, rising gas prices and a jump in market-based interest rates are all hitting at the same time. Plus, all that’s happening at a time when most households have used up their cushion of savings accumulated early in the pandemic.
New Fed projections show the jobless rate rising only to 4.1% in 2024 from 3.8% currently. In June, the Fed expected unemployment to reach 4.5%. The Fed now expects only a mild economic slowdown, and as a result, policymakers expect that short-term interest rates will need to stay above 5% through the end of 2024.
The new projections also signal doubt that the recent good news on inflation should be taken at face value.
Although the 3-month annualized trend in inflation could fall to 2.5% for August, the Fed still expects core PCE inflation to run 2.6% in 2024, unchanged from their June outlook.
Rising Real Interest Rates Jolt S&P 500
To sum up, policymakers expect the federal funds rate to end next year at 5.125%, while core inflation is at 2.6%. Both of those projections are likely too downbeat. But what is especially notable is that policymakers expect they’ll need to have about a 2.5% real federal funds rate (adjusted for inflation) to sufficiently restrain economic growth.
That implies the neutral real interest rate, which the Fed has generally estimated to be about 0.5%, is actually a couple of points higher, at least for the time being.
That message is one that Wall Street and the bond market seem to be taking to heart. The 10-year Treasury yield has surged close to 30 basis points in the past week, hitting a 16-year high of 4.64% intraday Wednesday.
Asked about the rise in market-based government bond yields on Sept. 20, Powell cited stronger growth and “more supply of Treasuries.”
Part of that extra supply comes from Fed quantitative tightening, the unloading of government-backed mortgage securities and Treasuries that the central bank bought early in the pandemic to boost financial market liquidity. The Fed is letting up to $95 billion in bonds run off its balance sheet each month.
A surge in Treasury issuance has compounded the impact of QT. And the current bout of market fragility isn’t helped by the blackout period for S&P 500 companies to conduct stock buybacks ahead of earnings.
But the market’s logic seems flawed. Surging interest rates are bound to quash demand and further depress inflation — and eventually bond yields.
The S&P 500 clawed out a tiny gain on Wednesday but is still down almost 7% since the end of July. A good reading on inflation on Friday could provide a welcome reality check.
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