Bottom line: core PCE (Personal Consumption Expenditure) inflation is down. The monthly annualized inflation rate fell from 1.8% in October to 0.7% in November; the year-over-year rate fell from 3.4% to 3.2%; and our preferred three month annualized rate fell from 2.3% to 2.2%. Ignoring the very noisy monthly rate, these declines are in keeping with our “prediction” of small changes in core PCE inflation based on the earlier CPI (Consumer Price Index) report for November.
Looking at overall PCE price inflation, the three month annualized rate plunged from 3.1% in October to 1.4% in November; the year-over-year rate fall was more modest, from 2.9% to 2.6%. These declines are in line with those of the earlier CPI report.
Given the continued decline in almost all measures of inflation it seems that the Fed will be looking closely at the “real” side of the economy. In fact, the recent revision of GDP by the BEA showed that the third (and final) estimate came in at 4.9%, down from 5.2% in the second estimate. According to the BEA the downward revision primarily reflected a decline in consumer spending, from 3.6% to 3.1%.
In its most recent announcement, the Fed noted,
Recent indicators suggest that growth of economic activity has slowed from its strong pace in the third quarter. Job gains have moderated since earlier in the year but remain strong, and the unemployment rate has remained low. Inflation has eased over the past year but remains elevated.
The latest revision to the third quarter tells us that the third quarter wasn’t quite as strong as previously reported. The Fed puts a lot of resources into nowcasting the US economy, so FOMC’s statement about slowing growth in the fourth quarter is probably a good read on the economy. The downward revision in the third quarter suggests that the fourth quarter may be even weaker than the Fed thought. With core PCE inflation edging closer to the Fed’s 2% target, and a weaker real side to the US economy, further hikes in the Fed funds rate seem unlikely.
According to the latest Bureau of Labor Statistics release, CPI (Consumer Price Index) inflation fell between October and November. While the one month annualized rate rose from 0.5% to 1.2%, the three month rate plunged from 4.4% to 2.2% and the 12 month rate was down marginally, from 3.2% to 3.1%.
Core CPI inflation was unchanged at the three month (3.4%) and 12 month (4%) horizons; the one month rate rose from 2.8% to 3.5%.
The FOMC (Federal Open Market Committee) focuses on inflation as measured by the core PCE deflator. However, November data for that measure of prices will not be released for two weeks. The scatter plot below shows that there’s a positive correlation between 3-month core CPI inflation and 3-month core PCE inflation. Given the marginal declines in 3-month and 12-month core CPI inflation, our best guess is that the corresponding core PCE inflation measures will also fall slightly. With the October 3-month core PCE inflation rate having come in at 2.4%, prospects look promising for core PCE inflation to settle in near the Fed’s 2% target.
The Federal Reserve held the policy rate steady and the median projections pointed to three rate cuts in 2024 and more the next few years, ending with: 4.6% in 2024, 3.6% in 2025 and 2.9% in 2026. The financial markets went bonkers: Dow up 500 points crossing the 37,000 mark to set a record.
On November 30, the Bureau of Economic Analysis (BEA) released PCE (Personal Consumption Expenditure) data for October 2023. The BEA notes a small monthly change in the PCE deflator (0.6% at an annual rate, down from 4.5% in September), and that the 12-month PCE inflation rate came in at 3.0% (down from 3.4% in September). These numbers largely mirror the earlier CPI (Consumer Price Index) release: the annualized monthly change fell from 4.8% to 0.5%; the 12-month rate from 3.7% to 3.2%. We prefer to look at the 3-month annualized inflation rate which also fell, from 3.7% to 3.2%; CPI inflation fell from 4.9% to 4.4%.
The cognoscenti know that the Fed’s preferred inflation measure is so-called core PCE inflation (taking out the food and energy components). By this measure, the monthly inflation rate fell from 3.8% to 2.0%, a larger decline than recorded by core CPI (3.9% to 2.8%). The 12-month inflation rate fell by 0.2 percentage points, to 3.5%; core CPI inflation fell by 0.1 percentage point to 3.0%. While our preferred 3-month annualized inflation rate fell, it was essentially unchanged at 2.4%. In contrast, the 3-month annualized change in core CPI rose in October, from 3.1% to 3.4%
In summary, the PCE inflation numbers for October confirm what was seen in the CPI inflation reported about two weeks earlier: inflation is down. How much depends on which series you focus upon. Keeping in mind that CPI inflation tends to run about 0.5 percentage points higher than PCE inflation, the data for October suggest that the US economy is approaching the Fed’s 2.0% inflation target.
Gross Domestic Product (Second Estimate)
On November 29 the BEA announced that real GDP for Q3 was revised up from 4.9% to 5.2%. While revisions to nonresidential fixed investment and state and local government spending were the leading causes of the increase, consumer spending was revised down.
Policy outlook
Given the continued decline in the inflation numbers and the continued strength in the output numbers, it appears the economy has digested the record increases in the Fed Funds rate without roiling the real side of the economy. There seems little doubt at this point that Fed policy is achieving its inflation reduction goal and may have reached the peak of the Fed Funds rate during this cycle. That is, nothing in the data points to the need for further increases in the rate and the market is suggesting some rate declines in 2024.
The recently released CPI (Consumer Price Index) numbers for September are a bit of a mixed bag for the inflation outlook. Our preferred 3-month annualized change in CPI rose from 4.0% in August to 4.9% in September. However, the monthly inflation rate fell from 7.8% to 4.9% at an annual rate. On a year-over-year basis, CPI inflation was essentially unchanged at 3.7%.
Those who prefer core CPI also confront a mix. On a 3-month basis, core CPI inflation rose form 2.4% to 3.1% (annualized) and the monthly inflation rate was up from 2.4% to 3.1%. On the other hand, the 12-month inflation rate was down from 4.4% to 4.1%.
Producer Price Index (PPI)
October 11 saw the release of PPI data for September. While the monthly rate of PPI inflation fell, from 9.4% to 6.3% at an annual rate, the 3-month rate rose from 5.6% to 7.7% while the 12-month change was up modestly, from 1.9% to 2.2%.
For what it’s worth, the monthly change in the personal consumption component of PPI fell from 39.2% to 16.9% (annualized) while its 3-month inflation rate rose from 15.2% to 19.3% (also annualized). On an annual basis, this measure of inflation rose from 1.4% to 2.1%.
Policy Implications
To be sure, there is good news from the CPI report: On a monthly basis, overall CPI inflation is down while the annual inflation rate is unchanged. Core CPI inflation is down at on an annual basis, but not at shorter horizons. However, both CPI and core CPI inflation are running hotter than the Fed’s 2% inflation target (granted, for (core) PCE inflation). PPI inflation tells much the same story as CPI inflation: down on a monthly basis, but up when measured over longer horizons. However, it’s not clear that PPI inflation signals future CPI inflation — particularly for the PPI for personal consumption. It seems unlikely that the PPI and CPI releases for September will change policyholders’ predilections.
On September 29, the BEA released data for the August PCE price index. On an annual basis, PCE inflation was up marginally, from 3.4% in July to 3.5% in August. More concerning: the annualized monthly inflation rate rose from 2.6% to 4.8%. Even our preferred 3 month measure is up, from 2.0 (the Fed’s stated target value) to 3.1%.
Of course, our loyal readers know that the Fed focuses on core PCE inflation which excludes the volatile food and energy components. By this measure, the outlook is decidedly brighter: The annual inflation is down from 4.3% in July to 3.9% in August. At an annual rate, the monthly inflation rate dropped from 2.6% to 1.8% (below the Fed’s target). Finally, the somewhat smoother 3 month inflation rate also fell, from 2.7% to 2.2%.
What are we to make of this? First, this reading on inflation is nearly a month old. CPI inflation, released 2 weeks ago, already told us that August inflation was up. So, the PCE numbers are hardly a surprise.
Second, while we’re not big fans of core or even supercore inflation measures, there is useful information to be had by looking at these other measures. In particular, the increase in overall inflation is driven in part by higher food and energy price inflation. To the extent that these increases are driven by transitory factors (the reason to look at core or our 3 month average in the first place), the increase in overall inflation in August may prove ephemeral.
Was it wise for the Fed to hold rates steady at their last meeting? Certainly the headline number makes it more difficult to discern the underlying trend in inflation; however, the core measures have all come down. Given that the Fed looks past some of the transitory measures, it seems the core measures have responded to the rate increases.
At an annualized rate, monthly inflation as measured by the Consumer Price Index (CPI) rose 7.8% in August, up from 2.0% in July. Our preferred measure of trend CPI inflation (the 3-month annualized) increased from 1.9% in July to 4.6% in August.
While we prefer to look at the overall CPI when looking to its trend, others prefer to look at core CPI inflation. Excluding food and energy, monthly inflation rose from 1.9% in July to 3.4% in August. However, the 3-month core CPI inflation rate actually fell, from 3.1% in July to 2.4% in August
What to make of all this? CPI inflation in August is up and well above the Fed’s 2% target for inflation. Comparing the overall CPI inflation with core CPI inflation shows that part of August’s increase in inflation is due to food and energy. The BLS specifically pointed to gasoline prices and the cost of shelter. Some commentators look at so-called `supercore’ CPI inflation, and that some of these supercore measures specifically exclude the cost of shelter. (What’s the end game for all these core measures? Will commentators be watching the price of bananas?)
August PPI
Producer Price Index (PPI) inflation for August similarly accelerated, from 4.9% in July to 9.3% in August (annualized monthly percent changes). The 3-month annualized PPI inflation rate also increased, from -0.1% (July) to 4.3% (August).
Looking instead at the PPI for personal consumption paints a more alarming picture: its monthly inflation rate rose from an annualized 4.3% in July to 40% in August! Its 3-month annualized counterpart also shows a marked increase, from -6.1% (July) to 15.4% (August).
It seems intuitive that producer prices should, eventually, be reflected in consumer prices. Looking across many years of data, the pattern that emerges is simply that inflation rates tend to move together. It seems difficult to make a case that higher PPI inflation is the harbinger of higher CPI inflation.
PCE for July
The PCE price index is released nearly a month after the CPI, and so August PCE inflation is not yet available. At an annualized rate, monthly PCE inflation rose slightly from 2.5% in June to 2.6% in July. On the other hand, the 3-month annualized PCE inflation rate fell from 2.5% (June) to 2.1% (July). Core PCE inflation shows a similar pattern.
Policy Outlook
Fed watchers know that its preferred measure of inflation is the PCE. The key question is: Will the large increases in CPI inflation in August also show up in the PCE inflation measures? It’s tempting to think that they must since the prices of individual items used in these indices are, presumably, essentially the same – the chief difference, then, being the weights associated with the prices of individual items. While PCE inflation generally tracks both CPI and core CPI inflation, these various measures of inflation exhibit considerable disparity.
Will the Fed take a pause, or continue raising its target for the Federal Funds Rate? If we knew the answer to this question, we’d probably be working on Wall Street. Answering this question probably means getting inside the heads of the voting members of the FOMC. Do they think that inflation is continuing to trend down? Or are the August CPI and PPI numbers the harbinger of an increase in inflation that needs to be nipped in the bud? Does the FOMC wish to avoid getting “behind the curve” as seems to have happened during the pandemic when they kept repeating that it was likely that the inflation was transitory due to supply chain issues?
The BEA release of the advance estimate of Q2 Real GDP showed an increase of 2.4% at a seasonally adjusted annual rate. The BEA noted:
The increase in real GDP reflected increases in consumer spending, nonresidential fixed investment, state and local government spending, private inventory investment, and federal government spending that were partly offset by decreases in exports and residential fixed investment. Imports, which are a subtraction in the calculation of GDP, decreased.
Bureau of Economic Analysis, July 27, 2023
The 1.6% increase in Personal Consumption Expenditures (PCE) represented nearly half of the contribution to overall growth, due to the fact that consumption is about 70% of total output. Real non-residential fixed investment increased 7.7% while real residential fixed investment declined 4.2%.
On a year-over-year basis, inflation as measured by the Personal Consumption Expenditures Price Index is the lowest since mid-2022, rising 3.0%, a full percentage point over the Fed’s 2% target. However, as emphasized in earlier posts to this blog, year-over-year measures are quite sluggish. Our preferred measure, the 3-month annualized inflation rate, is 2.5% in June, slightly higher than the 2.3% recorded in May. For what it’s worth, the 1-month annualized PCE inflation rate in June was 2.0%, up from May’s 1.5%.
As an aside, it seems curious to us that commentators are quite comfortable annualizing quarterly growth rates (as emphasized by the headline numbers for GDP growth), but are reticent to do the same with price data (for which headlines compute 12-month growth rates). Perhaps consistency is too much to ask.
What’s significant is that output growth accelerated from 2.0% in the first quarter of 2023 to 2.4% in the second quarter. In this context, the BEA’s discussion of the second quarter, quoted above, is strange. The BEA focused on the fact that GDP increased, listing off the major components that contributed to this increase (consumption, investment, government spending and imports) while noting those that detracted from the increase (exports and residential investment); see the following table.
Quarter 1
Quarter 2
Output
2.0%
2.4%
Consumption
4.2%
1.6%
Investment
-11.9%
5.7%
– Non-residential
0.6%
7.7%
– Structures
15.8%
9.7%
– Equipment
-8.9%
10.8%
– Intellectual Property
3.1%
3.9%
– Residential
-4.0%
-4.2%
Government
5.0%
2.6%
Exports
7.8%
-10.8%
Imports
2.0%
-7.8%
But why did output growth increase? The answer lies principally in the swings in investment and imports growth. Investment growth rose from -11.9% to 5.7%, transforming it from a drag on output growth to a contributor. Drilling deeper into investment, the growth rate of residential investment was largely unchanged (-4.0% to -4.2%). The big increase in non-residential investment growth was driven principally by investment in equipment, rising from -8.9% to 10.8%. To be sure, the growth in non-residential structures was very strong (9.7%), but it grew even faster in the first quarter (15.8%).
The growth rate of imports fell from 2.0% to -7.8%. However, since imports enter with a negative sign in the output identify, Y=C+I+G+X-M, the lower growth rate of imports contributed positively to output growth.
As noted by the BEA, growth of exports was negative in the second quarter (-10.8%) while it was positive in the first quarter (7.8%). While growth of consumption and government spending were both positive, their growth rates fell which has the effect of lowering quarter two output growth relative to the first quarter.
Overall, the strong growth in GDP coupled with the subdued (though still above the 2% target) price change shows a still-resilient real economy that is disregarding the increases in the Fed Funds rate. Based on available data, it is hard to make the case for a nascent recession in the U.S.
Personal Income
On Friday, the Bureau of Economic Analysis released personal income data. Real personal income growth fell from 8.5% in the first quarter to 2.5% in the second (both at annualized rates).
Disposable income data is also available on a monthly basis. The chart below shows that the first quarter was driven by very strong growth in January (21.9%) while the second quarter was hampered by negative growth in April (-0.4%).
Employment Cost Index
On Friday, the Bureau of Economic Analysis also released updated employment cost index data. Growth in the wages and salaries component fell from 4.9% in the first quarter to 4.1% in the second.
Overall, the current data suggest that the real economy continues to chug along at a respectable clip and the price numbers indicate that Fed policy is helping push down inflation. The Fed has indicated that the round of tightening is not yet over and the strength of the real economy gives no reason to alter that view.
The BEA announced May PCE (Personal Consumption Expenditure) data that reinforces the earlier CPI (Consumer Price Index) report: Inflation continues to creep down. Annualizing the month-over-month change in the PCE, inflation for May was 1.55%, well below the Fed’s 2% target. As we have commented before, these month-to-month changes contain a lot of noise and our preferred measure is the annualized 3 month change. By this measure, inflation for May was 2.45% – somewhat higher than the 2.2% reported earlier for the CPI. The headline year-over-year PCE inflation rate for May was 3.85%. As we have emphasized in previous posts, this year-over-year measure of inflation is slow to respond to changes in trend which means it will take some time for the year-over-year inflation rates to reflect the lower inflation rates that have come in over recent months.
Less rosy is the inflation picture coming from core PCE (that is, excluding food and energy). While the month-over-month rate was down in May – from 4.65% to 3.84% – the year-over-year and 3 month measures fell by roughly 0.1 percentage points. Presumably, the reason to look at core PCE inflation is that it provides a better gauge of underlying trend inflation than non-core PCE measures. But for our money, the 3 month PCE inflation rate does a good job capturing developments in trend inflation.
For June, expected inflation is now running below 2% at all horizons. Collectively, the results for CPI, PCE and expected inflation suggest that the tightening of monetary policy over the past year-and-a-half has brought down both actual and expected inflation. In this context, the Fed’s decision in June to pause its tightening of monetary policy seems like a good one, especially if one takes into account the well-known long and variable lags of the effects of monetary policy on the economy.
Finally, while we at Economic Snapshot usually do not comment on GDP (Gross Domestic Product) revisions, we are making an exception for the data released on Thursday by the BEA. The output revision was a very large 0.7 percentage points, from 1.27% to 2.00%. This upward revision of output can be attributed to upward revisions in consumption and exports, and a downward revision of imports (which has a positive effect on output since imports are subtracted from output). These effects were partially offset by small revisions in investment and government spending.
Second Revision
Third Revision
Difference
Output
1.27
2.00
+0.73
Consumption
2.65
2.93
+0.28
Investment
-2.10
-2.17
-0.07
Government
0.88
0.85
-0.03
Exports
0.66
1.00
+0.33
Imports
-0.75
-0.37
+0.38
GDP growth for the first quarter of 2023, and contributions to GDP growth by its major components.
The increase in real GDP was widespread according to the state GDP estimates. Real GDP increased in all 50 states in Q1. The largest increase came in North Dakota, 12.4% at annual rate and the lowest in Rhode Island and Alabama at 0.1%. Personal income increased in all but two states, Indiana (-1.0%) and Massachusetts (-0.9%).
The April employment report was released by the BLS and revealed a 253,000 increase in payrolls. However, there were downward revisions totaling 149,000 (down 78,000 in February and 71,000 in March) that threw a little cold water on the report. There were few sectors that had any decline except for temporary help services that shed 23,300 jobs. The workweek held steady at 34.4 hours so that total hours worked increased by 2.1%.
Measured over the past year, average hourly earnings rose 4.45% in April, up from 4.3%. However, when measured relative to the previous month, earnings growth accelerated from 3.3% to 5.9%. As the figure below shows, month-to-month growth rates for earnings are quite choppy. The 3 month change is somewhat smoother; measured this way, earnings growth rose from 3.4% to 4.3%.
The household survey showed that the labor force participation rate remained at 62.6% despite the labor force falling 43,000. The employment to population ratio was also unchanged at 60.4%. The unemployment rate fell from 3.50% to 3.39%.
Unemployment insurance claims spiked up to 264,000, the highest since October of 2021. Continued claims, however, were little changed.
Between March and April, there was little change in inflation as measured by 12 month percentage change in either the Consumer Price Index (CPI) or core CPI (excluding food and energy). However, the annualized monthly percentage change in the CPI rose from 0.6% to 4.5% while core CPI rose from 4.7% to 5.0%. As we have stressed in earlier posts, these annualized inflation rates are quite volatile while 12 month percentage changes respond sluggishly to changes in trend. The 3 month annualized percentage changes strike us as a good compromise between smoothing and quickly capturing trend changes. On this basis, CPI inflation was down slightly, from 3.8% in March to 3.2% in April; core CPI inflation was essentially unchanged at 5.1%. All of these measures of CPI inflation are currently running well above the Fed’s target of 2%.
Given that CPI inflation is higher than the Fed’s 2% target, it may not be surprising that inflation expectations similarly exceed this 2% target. While the May readings for the 1 year and 2 year expected inflation are unchanged at 2.65% and 2.4%, respectively, the 5 year and 10 year expectations rose marginally.
It seems that monetary policymakers no longer look at what’s happening to money growth. That the Fed changed its definition of monetary aggregates starting in May 2020 makes it difficult to take a long view on money growth. Nonetheless, since May 2021 (given the change in the definition of “money” in May 2020, the earliest date for which year-over-year growth rates can sensibly be computed) growth of the monetary aggregates M1 and M2 has slowed. Indeed, both have been contracting since late 2022. A traditional monetarist like Milton Friedman would likely look at the chart below and predict future deflation. One way to think through all this is via the quantity theory of money: Mv = PY where M is money, v velocity, P the price level, and Y real output. This relationship can be recast as: money growth + velocity growth = inflation + real output growth. If velocity is roughly constant (so that its growth rate is 0), and long run real output growth is constant, the quantity theory of money predicts a tight relationship between money growth and inflation. As Milton Friedman put it, “Inflation is always and everywhere a monetary phenomenon.”
Of course, there have been important developments within the banking system. One such development is that the Fed now pays interest on excess reserves of banks held at the Federal Reserve Banks (“excess” meaning above-and-beyond what is required to satisfy reserve requirements). Plausibly, changes in the gap between this interest rate on reserves and the Federal Funds Rate (the rate banks pay in an overnight market for reserves) might explain the above deceleration of money growth. However, as shown below, the interest rate on reserves and the Fed Funds Rate move in lock step.
The March CPI (Consumer Price Index) brought decidedly mixed news. Year-over-year, CPI inflation fell from 6% in February to 5% in March. Indeed, the year-over-year inflation rate has trended down since mid-2022. However, as we have pointed out in earlier posts, year-over-year measures of inflation are slow to reflect recent changes in trend since they are 12 month averages of past monthly inflation rates. The good news is that monthly (annualized) inflation is down from 4.5% (February) to 0.6% (March), well below the Fed’s 2% inflation target. A glance at the chart below will remind regular readers that monthly inflation rates exhibit considerable variability. Our preferred measure is the 3-month average of monthly inflation rates. This measure declined more modestly, from 4.1% to 3.8%. More importantly, the 3-month average inflation rate is still well above the Fed’s 2% target.
The news is decidedly worse when looking at core CPI inflation (that is, excluding the volatile food and energy components). On a year-over-year basis, core CPI inflation rose from 5.5% in February to 5.6% in March. On the other hand, the monthly core CPI inflation rate fell from 5.6% to 4.7%. Again, we prefer to look at the 3 month average to gauge the direction of trend inflation. The 3 month average of core CPI inflation fell slightly, from 5.2% to 5.1%. More troubling is that these measures are all well above the Fed’s 2% inflation target.
The producer price index (PPI) was released today that offered up a little more good news. The PPI fell 0.5% in March. Moreover, as noted by the BLS, “two-thirds of the decline in the index for final demand can be attributed to a 1.0-percent decrease in prices for final demand goods. The index for final demand services moved down 0.3 percent.”
Finally, short term inflation expectations have risen: For the one year horizon, from 2.1% in March to 2.6% in April; at the two year horizon, from 2.2% to 2.4%. These developments are, presumably, unwelcome by policymakers who are worried about higher inflation expectations becoming entrenched. Fortunately, the five year expected inflation rate fell from 2.2% to 2.1% while 10 year expectations dropped from 2.3% to 2.1%.
Overall, as mentioned at the outset, the news is mixed. Yes, the CPI is down. But, the year over year core CPI is up. The main reason for the difference between the CPI and CORE CPI is that energy prices fell: gasoline, down 17.4%, and fuel oil, down 14.2%. Given the highly volatile nature of food and energy it is useful to pay attention to the core measure.
