Fed Easing Is Coming, Regardless of the Data (January 15, 2024)

A “constitutionally dovish” central bank using the core PCE risks locking in higher inflation  

By Lisa Beilfuss

Prevailing questions across financial markets–whether the Federal Reserve will ease soon and aggressively–miss the forest for the trees. The better question: How much of a mistake will such policy easing turn out to be?

U.S. central bankers say they are data dependent, giving markets the impression that monetary policy is effectively technical. But data often send conflicting messages. A dual mandate of price stability and maximum employment requires trade offs, and politics inevitably seep in. In reality, the Fed shifts its data emphasis to fit preordained policy decisions. 

The Fed in 2020 adopted a flexible average inflation-targeting regime, which it used to justify a delayed response to rampant inflation. Fed Chair Jerome Powell has backed out housing on top of food and energy to come up with what he calls “supercore inflation.”  

So-called core measures of inflation–silly because households and businesses can’t exclude food and energy–were introduced in 1975, no coincidence given the sources of high inflation during that era. Treasury Secretary Janet Yellen, during her tenure as Fed chair, focused on alternative measures of employment than the unemployment rate to justify loose policy. 

“They cherry pick the data to do what they want to do and change to justify the policy they want to take,” says Stephen Miran, fellow at the Manhattan Institute and former senior advisor at the Treasury Department. “Markets think the Fed has a constitutionally dovish bias, and I don't see reasons to think the market is wrong.”

Miran gives several reasons for such bias. First, inflation was subdued for a long time and so there is muscle memory of being complacent. Second, many of the dominant personalities at the Fed have been ideological doves. Chairs aim for consensus, and Miran notes it has been decades since a Fed governor dissented. Third, politics are inescapable when chairs and governors are appointed by presidents and confirmed by the Senate. 

“This is a Fed that has managed to work climate risk into bank regulations. It is hard to believe it’s a Fed that isn’t political,” says Miran. 

All of this creates a backdrop investors might consider alongside a widening gap between two major inflation indicators. The wedge between the core PCE and core CPI suggests forthcoming easing may reignite pricing pressures that are already hotter than central bankers acknowledge. 

Since 2000, the Fed has targeted the core PCE, or the personal consumption expenditures index excluding food and energy. The index is on track to fall to the lowest rate since prices began to run in the spring of 2021. Economists at Deutsche Bank predict a 2.9% year-over-year rate for December, down from 3.2% in November.

Before 2000, the Fed relied on the core CPI, or the consumer price index excluding food and energy. That is one reason the public, including the media, still focuses on the CPI over the PCE. The CPI unexpectedly rose in December, increasing 0.3% month-over-month and pushing the year-over-year rate to 3.4% from 3.1% in November. Core CPI rose 3.9% last month versus 4% in November. 

Core CPI has long run hotter than core PCE, but the difference has been much smaller. St. Louis Fed data show that in the five years leading up to the onset of the pandemic, the gap averaged four-tenths of a percentage point. Going back 20 years, the gap averaged three-tenths of a percentage point. Now, it is a full point.

There are two main factors behind the current wedge. Thinking through them should leave investors skeptical of the notion that inflation has been defeated–and that even the significantly hotter CPI is capturing real-world inflation.

First, the PCE weighs healthcare more heavily than the CPI. What is more, the PCE includes expenditures made on behalf of consumers. This means it uses Medicare and Medicaid reimbursement rates set by the government, pulling in artificially low prices that may not reflect what consumers are actually spending. 

Miran puts the problem this way. When people think about inflation, they probably don’t consider Medicare reimbursements to hospitals and instead consider what they experience–from food and gas to haircuts and hotels. If underlying inflation is closer to where CPI is running, declaring victory based on the PCE risks entrenching higher underlying inflation in the economy. Undue attention on costs not experienced by consumers–what the PCE measures by design–thus means the Fed will create more inflation in prices directly experienced by consumers, Miran says.

This isn’t to say that swapping the CPI, which counts expenditures made directly by consumers, is an perfect fix. Here is one example of its own flaws. The CPI calculates health insurance costs based on lagged insurer profitability, and the index showed a 27% decline in the category last year. Yet insurance giant UnitedHealth Group (ticker: UNH) reported a 5.6% increase in revenue per member for 2023. At least in this category, CPI is also understating real-world inflation.

Housing is the second reason for the inflation-gauge gap. The CPI weighs housing more heavily than the PCE, with shelter accounting for about 40% of the core index. Some strategists have downplayed relatively high CPI readings based on consensus expectations for rent deflation, but the notion is faulty. 

Enduring Investments founder Michael Ashton says the private data behind falling-rent assumptions are low quality. Costs never improved for landlords and keep getting worse, all while a mismatch remains between available housing stock and where people are moving, he says. Ashton warns that rent inflation will outpace expectations and is more likely to speed up than slow down. 

An updated forecast from real-estate marketplace Zillow (ticker: Z) underlines Ashton’s point. The company now expects U.S. home prices to rise 3.5% this year, up from an earlier forecast of flat prices. The price of shelter as measured by the CPI tends to follow home prices by about a year.

The debate over whether the Fed will ease soon and more than officials say misses the bigger point. The core PCE will easily allow the central bank to justify dovish policy, supporting certain asset classes, such as commodities, in the near term. It may also entrench higher inflation and give way to a new wave.