Higher for Longer? Maybe for Inflation (October 1, 2023)

Higher energy prices are excluded from the Fed’s favored inflation data, but not from real-world budgets

By Lisa Beilfuss
October 1, 2023

The Federal Reserve may already have cover to abandon the higher-for-longer interest-rate stance it is telegraphing, potentially setting up a period of elevated inflation that the real world feels but data clouds.

Last week, Praxis wrote about why it is worth maintaining some skepticism over the central bank’s pledge to keep rates higher for longer, where cuts don’t happen in 2024, and rates through 2026 remain above what officials think is the roughly neutral policy rate of 2.5%.

Of all the monthly and quarterly inflation metrics, the Fed favors the core PCE, or the personal consumption expenditure index excluding food and energy. The government on Friday reported a 3.9% increase in the August index from a year earlier, still about twice the Fed’s target. From a month earlier, however, the core PCE rose only 0.1%--the smallest monthly gain since November 2020. 

What is more, the core PCE increased just 2.2% when you use a 3-month annualized rate. That is down from a 6-month annualized rate of 3%, and within striking distance of the Fed’s 2% target.

The latest inflation data was interpreted by economists as unambiguously good and scrambled expectations across Wall Street. Goldman Sachs chief economist Jan Hatzius says the risk to his forecast for a year-over-year core PCE of between 2-2.5% by late 2024 is now on the earlier side. And the Fed’s own recently-updated forecasts look too high. For the central bank to hit officials’ median expectation for 3.7% core PCE at the end of the 2023, it would take an acceleration to at least a 0.31% average rate in the month-over-month core PCE for September through December, says Inflation Insights founder Omair Sharif.

The faster-than-expected downtrend in the core PCE means that, barring a reversal, the Fed is probably done lifting rates this cycle, even as traders place about 35% odds on another 0.25% increase in December. It also means the central bank may have what it wants to begin easing policy sooner than it says and earlier than markets have lately come to believe.

The problem, though, is that the core measures of inflation that shape monetary policy don’t capture the inflation consumers feel. That may be especially true for the PCE, which tends to reflect less inflation than the CPI, or consumer price index. As Cleveland Fed economists have explained, the CPI is based on a survey of what households are buying, while the PCE is based on surveys of what businesses are selling.

As for using core measures, it makes sense in theory to exclude often-volatile food and energy prices in order to smooth out the inflation picture. But methodology aside, households and businesses don’t have the luxury of backing out the prices of essentials. Government data show food and energy categories represented about a fifth of overall consumer spending in the second quarter.

For the past six months, headline, or total, PCE has been running below core inflation as energy prices fell from year-earlier levels. But that dynamic looks set to flip back, with core inflation metrics masking some real-world pricing pressure.  

U.S. West Texas Intermediate futures topped $95 a barrel last week, the highest since August 2022. Even after pulling back to about $90 a barrel, WTI is up 23% this year and 28% over the past three months. Oil is a major input for U.S. food prices, which rose 4% in the latest month from a year earlier. 

Many analysts say slowing or reversing growth in the U.S., China and elsewhere will pinch energy demand, in turn lowering prices. But there aren’t yet real signs of falling energy demand. Moreover, oil supply remains short.

U.S. Energy Information Administration data show crude oil inventories are down 3.3% from a year ago and off 4% from the 5-year average for this time of year. While the U.S. is now pumping an extra million barrels per day versus January 2022, extended production cuts by Saudi Arabia and Russia are outpacing that increase. 

That isn’t to mention the 40-year low in the U.S. Strategic Petroleum Reserve, or SPR. The Biden administration had said it would replenish emergency reserves when oil was roughly $70 a barrel. It didn’t, and the government may wind up supporting higher oil prices when it inevitably has to restock the SPR.

Natural-resource investors Leigh Goehring and Adam Rozencwajg of Goehring & Rozencwajg say that oil is on the verge of a sharp rally. “We are adamant in our belief that this bull market has only begun and prices will increase,” they wrote in a memo last week, adding that they are “amazed at the level of investor apathy.”

One factor behind Goehring and Rozencwajg’s bullish sentiment may be underappreciated. The U.S. in 2022 released 220 million barrels from its SPR, amounting to 607,000 barrels per day. The liquidation continued into 2023, in part because the Bipartisan Budget Act of 2018 mandated that the U.S. sell oil from the SPR to fund spending bills. During the second quarter, the US released 25 million barrels, or 260,000 barrels per day, from the SPR.

But ongoing SPR sales under the 2018 act are now done. The deal said SPR sales would end if reserves fell to 350 million barrels, from about 650 million barrels at the time the act was passed. After emergency reserves recently fell below that threshold, the Biden administration said it would cancel all planned sales from the SPR. With the U.S. no longer selling several hundred thousand barrels per day from its strategic reserves, Goehring and Rozencwajg say commercial inventories are set to fall sharply, pushing prices higher.

All of this suggests that one main factor behind cooling inflation–lower oil prices–may be fleeting. But core inflation measures won’t directly reflect renewed energy-price strength, potentially allowing Fed officials to begin easing policy sooner than predicted. 

For households and businesses, it may be inflation that stays higher for longer–regardless of what policy-setting data portrays.