The Fed’s New Key Inflation Rate Rose In Q4, But S&P 500 Rallies

The Fed’s favorite inflation rate, the core PCE price index, eased to an annual rate of 3.85% in Q4, new data released with the GDP figures showed on Thursday. While the monthly PCE inflation data out on Friday at 8:30 a.m. ET will draw closer scrutiny, the easing of core prices on a quarterly basis suggests that no major unintended surprises are in store. That helped lift the S&P 500 to its highest level since the last Fed meeting in stock market action Thursday.


Wall Street expected Friday’s data to show the PCE price index was unchanged in December, when the annual inflation rate slowed to 5% from 5.5%. Core PCE prices were seen rising 0.3%, as the core inflation rate eased to 4.4% from 4.7%.

The S&P 500’s rally was built on the belief that inflation will continue its steady decline even as the US economy avoids a hard landing. That could allow the Fed to pause rate hikes after quarter-point moves next Wednesday and on March 22. Markets expect the Fed’s rate hikes to turn into rate cuts later this year.

Fed Chairman Powell’s New Inflation Rate

The price hike scenario appears to be supported by Q4 PCE inflation data. However, it may be too early to celebrate. That’s because Fed Chairman Jerome Powell has tried to shift the focus of policymakers and investors to a new headline rate of inflation: PCE services excluding energy and housing.

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That category, which includes healthcare, education, haircuts, hospitality and more, accounts for about 50% of consumption. Powell has called it “the most important category for understanding the evolution of future core inflation.” This is because price changes for such services are closely related to wage growth. If the labor market remains very tight, high service inflation may persist.

So what does the Q4 PCE data show? The news isn’t good: The price index for core PCE services minus housing rose at an annual rate of 4.7% in Q4. The inflation rate for core services PCE minus housing over the past 12 months rose to 4.4% from 4.2%.

The data may be somewhat surprising. When the CPI data comes out on January 12, some analysts point to good news for Powell’s focus on inflation in services excluding shelters. The CPI measure shows prices in this category fell to an annual rate of 1.2% in Q4.

But that underscores the big difference in how the government measures PCE inflation and CPI inflation.

PCE Vs. CPI inflation

The PCE covers a wider range of expenses than the CPI, which only reflects out-of-pocket expenses. The distinction is important, especially when it comes to health care. Employers and the government pay most of the medical bills, which the CPI ignores. While medical care services make up only 7% of the CPI household purchases basket, health care services account for nearly 16% of PCE.

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Not only that, but the medical services inflation gauge CPI began to fall rapidly in October. The decline should continue, but it doesn’t really show the current price. It mirrors the insurance company’s reported profits last fall.

Among many other differences, Powell’s new PCE service inflation measure also includes eating out. However, the CPI data groups food outside the home with goods, not services.

What Does This Mean For The S&P 500?

If Powell’s “all-important” inflation rate continues to be raised in Q4, why is the S&P 500 rallying?

That may be partly due to income, with Tesla (TSLA) gets a famous pop. It’s also possible that investors aren’t paying much attention to Powell’s new inflation category.

The focus on core services PCE minus housing is so new that it is not provided in Commerce Department reports or the subject of Wall Street estimates. Calculating IBD to derive the quarterly data in this article and the monthly data in the accompanying chart required a multi-step process.

Persistent inflation in Powell’s service category could keep Fed policy tighter for longer, but that’s far from clear. The real key to inflation and Fed policy is wage growth. The December jobs report showed wage growth slowed to a 4% annual rate in Q4. That’s not too far above the 3.5% wage growth that Powell said could be consistent with the Fed’s 2% inflation target.

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If moderation in wage growth continues, the Fed can be more patient in waiting for inflation to subside. Two big reports on wage growth next week loom large: Tuesday’s Q4 Employment Cost Index and Friday’s January jobs report.

Meanwhile, the S&P 500 remained in rally mode, up 0.6% in Thursday afternoon trade. After trading on both sides of its 200-day line for the past two weeks, the S&P 500 has now surged to its highest level since Dec. 14. This is a major intersection. The S&P 500’s past few attempts to break out of its 200-day line have been quickly broken.

As of Wednesday’s close, the S&P 500 was 16.3% below its record closing high, but up 12.3% from its Oct. 12 bear market low close.

Be sure to read IBD’s The Big Picture daily to stay in tune with fundamental market trends and what they mean for your trading decisions.


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