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The Fed's primary inflation gauge, Core PCE, is running nearly 100 basis points hotter than Core CPI, the benchmark for inflation markets. This creates a risk of the Fed overtightening policy based on sticky PCE data, which could lead to a weaker-than-expected inflation outcome for CPI and thus cause underperformance for CPI-linked bonds.
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The Bureau of Economic Analysis is changing how it calculates key components of the Personal Consumption Expenditures (PCE) deflator, the Fed's preferred inflation gauge. These changes will lower the reported inflation figure, complicating year-over-year comparisons and Fed policy analysis.
Despite progress on shelter inflation, core services excluding shelter (the "super core") remain sticky. This persistence, linked to wage components, is a primary reason the Federal Reserve will likely pursue a gradual pace of interest rate cuts rather than a more aggressive easing policy.
While economists focus on the firmer 'core' inflation, financial markets that trade inflation (like TIPS and swaps) price off the 'headline' number. This headline figure has consistently surprised to the downside for 14 of the last 18 months, creating a bearish dynamic for inflation-linked assets.
After accounting for measurement quirks in both CPI and PCE, the podcast's economists converge on an estimate for "true" underlying inflation around 2.7-2.8%. This consensus view suggests that while official measures are noisy, the underlying trend is still meaningfully above the Fed's 2% target.
The gap between Core PCE (3.3%) and Core CPI (2.5%) inflation is driven by how each index weighs shelter and measures financial services. CPI gives more weight to disinflating shelter, while PCE is inflated by a stock market-linked measure for financial services.
Despite a downside surprise in CPI, the Fed's preferred inflation gauge, Core PCE, is still rising. This growing negative wedge between the two metrics leads to a more hawkish Fed policy than CPI alone would suggest, creating a negative outlook for TIPS in the near term.
Recent bond market volatility stems from a Fed credibility issue, not just rate expectations. Uncertainty over which inflation metric the Fed is targeting (e.g., Core PCE vs. Dallas Trimmed Mean) creates ambiguity about its reaction function, fueling investor fear and raising the term premium.
The US economy is showing stagflationary characteristics. GDP growth is weakening and projected to remain soft, while key inflation measures like PCE are nearly double the Fed's 2% target. This toxic mix limits the Federal Reserve's ability to support the economy without worsening price pressures.
Focusing on falling oil prices as a sign of easing inflation is simplistic. Leading indicators like the sectoral breakdown of payrolls and a core PPI that has jumped from a 3% to a 5% handle in six months suggest a stickier, more concerning inflation outlook for the Federal Reserve.
The new Fed Chair's suggestion to use measures like the trimmed-mean CPI isn't new. These same metrics were used by Fed governors in 2021 to justify delaying rate hikes. They failed to capture the breadth of rising inflation then, which suggests caution should be used before elevating them as primary policy guides now.