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A Modest PCE Rise Means The Fed Is Unlikely To Change Policy On Interest Rates

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by: Tim Worstall
Summary

The single most important inflation measure for the Federal Reserve is the personal consumption one - PCE.

This is soft, lower than target, but the Fed thinks this is transitory.

I'd thus expect no change to interest rate policy in the near future.

Why Worry About Inflation?

The usual end of a boom is when the Federal Reserve raises interest rates in order to choke off inflation. We'd thus like to keep an eye upon the Fed raising interest rates, bringing the economic growth to a halt for a while. The obvious reason being that stocks, equities, suffer going into a recession, gain substantially on the recovery.

Thus the near obsession with which people mull over the mutterings from the Fed. Currently they're being very open about what they want, what they're looking at. They've told us all what their inflation target is, even which variant of inflation it is they're using. We can thus look at the same information and second guess as to whether interest rates are going to rise.

As far as we can tell, and my best opinion is, that we're going to get the one already announced further rise in rates this year and then nothing more.

PCE Deflator

A deflator and an inflation rate are not exactly the same thing but they're such closely related ideas that's it's not worth explaining or worrying about the difference. We can thus use the PCE deflator as a synonym for the PCE inflation rate.

The Federal Reserve has told us that it's this, the personal consumption expenditure, inflation rate that they're using as their guide. Of all of the variants (CPI, RPI, etc.) this is the one they think best represents the general reality out there. Their target is for this PCE rate to run at 2%, consistent with full employment. Substantially below and we can expect them to cut rates, above and raises them.

Actually, A Little More Complex

The Fed wants to raise rates anyway. The general view is that being able to lower rates in times of economic stress is very useful, very helpful. When rates are already low not so much. Rates haven't risen back to where they were before the Crash and the Fed would like them to. They're just not willing to push them up at damage to the economy - that would be more than a little ridiculous. But if there's room they'd like them higher. They are, that is, biased to higher rates. So they're being asymmetric in their rate setting, erring on the higher side over time.

Back To PCE

PCE inflation, or the deflator, has been below the Fed target for years now. That's why we've had such minimal rises in rates, that's the asymmetry coming through. It's still subdued:

Real DPI increased 0.3 percent in May, and real PCE increased 0.2 percent. The PCE price index increased 0.2 percent. Excluding food and energy, the PCE price index increased 0.2 percent.

Few of us really intuitively grasp monthly inflation numbers, this is more helpful:

PCE numbers (PCE Deflator from Bureau of Economic Analysis)

What's This Core Stuff?

When we measure inflation of course we're interested in relative price changes. But that's not the only thing we might want to pick out of the information. We might prefer to see what's happening to the general price level, leaving out oddities caused by weather, or a war somewhere else. You know, just imagine, we might.

Actually, we in fact do. For if inflation is up because Iranian oil is off the market - say - then this isn't something that a change in US interest rates is going to anything about. But if we're in a general inflation because US domestic demand is too high for current productive capacity then an interest rate change will indeed take care of it all. So, we like to look at inflation minus the two known to be most volatile sets of prices. Food and energy. That's the "core" inflation measure and near all of our various inflations can be so altered, Core CPI and so on.

The Fed And Core PCE

The Feds have told us that the inflation rate they're using as their 2% target is "core PCE". This is as we can see below target. It's been bouncing around a bit but below that target:

PCE

(PCE Deflator from Moody's Analytics)

At which point we might declare that the Fed's going to lower rates in order to get that inflation measure up. Well, yes, except as Moody's analytics says:

The May inflation data likely won't temper either the Federal Reserve's dovishness or easing bias. Rather, the heightened trade tensions between the U.S. and some of its trading partners will be more worrying from the Fed's perspective than the recent softening in inflation, which the central bank believes is transitory.

That is, it's all just one of those things, rather than a general weakening of demand in the economy. And the risk isn't on the upside either. So, no likely change in the already announced path of interest rates.

My Prediction For Interest Rate Changes

We've no sign of incipient inflation above target in the US economy. The Fed's favorite measure for their 2% inflation target is running below that target, but the general opinion is that's just a confluence of details, not a general weakening. We know the Fed wants to raise interest rates in order to give more monetary space to deal with the next turn of the business cycle. We've also had very strong indications to expect one more rate rise - of 0.25% - this year. Anything else would be a change in policy.

I expect no change in policy. One more, small, Federal Reserve rate rise this year. Assuming - obviously a large assumption - no degradation into a proper trade war there will be no rate cut to boost the economy, no greater rise to choke off the non-existent inflation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.