Column: The Fed’s inflation problem is getting harder to ignore

It has been the case for many years now that Core PCE, that is, the Personal Consumption Expenditures index, excluding food and energy, has been the US Federal Reserve’s preferred inflation measure.

It is understood that when the Fed talks about its 2% inflation target, it is core PCE that they’re talking about.

It is also understood that Kevin Warsh, who replaced Jerome Powell as Fed Chair in May, isn’t a huge fan.

But market analysts have not yet switched to his preferred inflation measure, which happens to be some trimmed version of CPI, once again excluding food and energy.

That aside, the latest Core PCE update was released this week. It came out at +3.3% year-on-year.

Not only was this bang in line with expectations, but also unchanged from the previous update. 

The only problem with this latest release is that it remains way above that 2% Fed inflation target, and has been for well over five years now.

Perhaps more concerning is that this data series is not only showing US inflation to be remarkably sticky, but it also has a slight upward trend.

It may have been unchanged from last month, but it has edged up significantly from 2.6% in April last year.

In contrast, Core CPI, arguably the most widely followed inflation measure, came in at +2.5% last month, matching levels seen at the beginning of this year, which were the lowest readings since April 2021.

This got investors very excited, and it led to a drop in the market’s rate hike expectations from the Fed through to year-end. 

So, there’s some confusion out there, not helped by Kevin Warsh’s rejection of forward guidance from the central bank. What else?

Oh yes, there’s the Producer Price Index (PPI), which measures wholesale inflation, which most analysts agree leads consumer inflation.

When wholesale prices are rising, that means that producers are either going to pass on their increased costs to consumers where they can.

This takes a larger chunk out of pay packets for basic goods and services.

Alternatively, the companies eat these costs themselves, which will have a negative effect on margins and therefore overall profitability, all other things being equal.

If so, then this has the potential to be a significant headwind for stock prices. The good news is that Core PPI has fallen since April this year.

The bad news is that it came in at +4.2% in July. No wonder Fed officials are concerned about inflation, with three out of twelve FOMC members citing rising inflationary pressures as their reason for voting for a 25 basis point rate hike at the last meeting in July. 

But how concerned should they be? There are signs that, AI infrastructure spending aside, not all is swell with the US economy.

Recently, there have been two consecutive weak Non-Farm Payroll reports, a poor Retail Sales number, and some disappointing and conflicting quarterly earnings updates from the big retail corporations.

Of these, Walmart’s report was the most concerning, with the slowest quarterly sales growth in six years.

But other retailers also told a story, one in which higher earners continue to spend, while lower-income households are showing signs of strain.

That doesn’t look like an environment that would respond well to a hike in borrowing costs.

On Friday the 28th of August, Fed Chair Warsh will deliver the keynote speech at the Jackson Hole Economic Symposium. Investors are desperate for him to give them a steer on what the Fed will do on interest rates. 

Will he go hawkish or dovish? After all, these are febrile times. US Treasury Secretary Scott Bessent has been doing his darndest to slap down the dollar.

He recently announced that the Treasury would double the size of its purchases of longer-dated government bonds, a move which saw yields drop and the US dollar slump.

This was Mr Bessent's second attempt to drive down the dollar, the first being his decision to join Japan's Ministry of Finance in an intervention to support the yen at the end of July.

It is no secret that Mr Bessent, along with President Trump, wants a weaker dollar to help US exporters sell their goods overseas. Whether they'll get it or not is another matter.

And as to whether Mr Warsh will express an opinion on rates or inflation, given his drive to make the Fed less transparent than under his last three predecessors, I say he says nothing.

(This is a fortnightly column by David Morrison. He is a Senior Market Analyst at Trade Nation. Views are his own.)