Core PCE Inflation Slows to Lowest Since 2021

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The Personal Consumption Expenditures (PCE) price index rose 0.4% in January from the previous month, notching its largest monthly gain since January 2023, according to data released by the Commerce Department on Thursday. On an annual basis, headline PCE inflation, which includes volatile food and energy categories, slowed to 2.4% from 2.6% in December.

More importantly, the Federal Reserve’s preferred core PCE inflation gauge, which excludes food and energy, increased 0.4% month-over-month and 2.8% year-over-year. The 2.8% annual increase was the slowest since March 2021 and matched analyst estimates. However, the monthly pop indicates inflation may be bottoming out after two straight months of cooling.

The data presents a mixed picture for the Federal Reserve as it fights to lower inflation back to its 2% target. On one hand, the slowing annual inflation rate shows the cumulative effect of the Fed’s aggressive interest rate hikes in 2022. This supports the case for ending the hiking cycle soon and potentially cutting rates later this year if the trend continues.

On the other hand, the sharp monthly increase in January shows inflation is not yet on a clear downward trajectory. Some components of the PCE report also flashed warning signs. Services inflation excluding energy picked up while goods disinflation moderated. This could reflect the tight labor market and pent-up services demand.

Markets are currently pricing in around a 40% chance of a rate cut in June. But with inflation showing signs of stabilizing in January, the Fed will likely want to see a more definitive downward trend before changing course. Central bank officials have repeatedly emphasized they need to see “substantially more evidence” that inflation is falling before pausing or loosening policy.

The latest PCE data will unlikely satisfy that threshold. As a result, markets now see almost no chance of a rate cut at the March Fed meeting and still expect at least one more 25 basis point hike to the fed funds target range.

The January monthly pop in inflation will make Fed officials more cautious about declaring victory too soon or pivoting prematurely to rate cuts. But the slowing annual trend remains intact for now. As long as that continues, the Fed could shift to data-dependent mode later this year and consider rate cuts if other economic barometers, like employment, soften.

For consumers and businesses, the inflation outlook remains murky in the near-term but with some positive signs on the horizon. Overall price increases are gradually cooling from their peaks but could plateau at moderately high levels in the first half of 2024 based on January’s data.

Households will get temporary relief at the gas pump as energy inflation keeps slowing. But they will continue facing higher rents, medical care costs, and services prices amid strong demand and tight labor markets. Supply chain difficulties and China’s reopening could also re-accelerate some goods inflation.

Still, the Fed’s sustained monetary policy tightening should help rebalance demand and supply over time. As rate hikes compound and growth slows, inflationary pressures should continue easing. But consumers and businesses cannot expect rapid deflation or a return to the low inflation regime of the past decade anytime soon.

For the FOMC, the January data signals a need to hold steady at the upcoming March meeting and remain patient through the first half of 2024. Jumping straight to rate cuts risks repeating the mistake of the 1970s by loosening too soon. Officials have to let the delayed effects of tightening play out further.

With inflation showing early tentative signs of plateauing, the Fed is likely on hold for at least a few more meetings. But if price increases continue declining back toward 2% later this year, then small rate cuts can be back on the table. For now, the January data highlights the bumpy road back to price stability.


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