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FED WATCH  •  May 30, 2023  •  Jon Wolfenbarger

Accelerating Inflation Is Pressuring Fed To Keep Hiking Rates

SPLIT, CROATIA — Investors have been jumping over each other trying to bid up prices on the most expensive sector in the stock market: Tech. This is all predicated on Jay “Transitory Inflation” Powell’s belief that inflation will soon fall to the Fed’s 2% target so the Fed can slash interest rates.

Unfortunately for the “permabull” narrative, that is not happening.

Inflation Is Accelerating Again

The Fed’s favorite inflation metric is “Core PCE”, which is the personal consumption expenditures (PCE) price index of a broad range of goods and services purchased by consumers, excluding volatile food and energy prices.

As shown in the chart below, Core PCE (blue line) accelerated to 4.7% in April from 4.6% in March and was above expectations of 4.6%. That is nearly 2.5 times higher than the Fed’s 2% inflation target. Note that Core PCE increased 4.9% in April 2022, so these are high inflation rates on top of already high inflation rates. 

PCE (green line) also accelerated, from 4.2% in March to 4.4% in April. Perhaps most importantly, Median PCE (orange line) increased 5.8%, nearly 3 times higher than the Fed’s target and in line with the narrow range of 5.8% to 5.9% it has been in since July 2022. 

Source: Cleveland Fed

Cleveland Fed research has determined the importance of the Median PCE metric, noting:

“Median PCE inflation is the one-month inflation rate of the component whose expenditure weight is in the 50th percentile of price changes. By omitting outliers (small and large price changes) and focusing on the interior of the distribution of price changes, the median PCE inflation rate can provide a better signal of the underlying inflation trend than either the all-items PCE price index or the PCE price index excluding food and energy (also known as the core PCE price index). Research from the Cleveland Fed shows that the median PCE inflation rate can be useful for estimating the underlying trend in inflation and forecasting future inflation.”

Consumer Inflation Expectations Are Rising Again

The Fed believes consumer inflation expectations are very important in driving future inflation rates, since they help determine worker wage negotiations and the prices businesses must charge to pay those wages.

Unfortunately, consumer inflation expectations remain high. The University of Michigan consumer survey in May showed that consumers expect 4.5% inflation over the coming 12 months, 2.5 times higher than the Fed’s target. The chart below shows consumer inflation expectations for the next year have been increasing in recent months.

Source: University of Michigan

The same survey shows consumers expect inflation to rise 3.2% annually over the next five years. That increased from 3.0% in April and is over 50% higher than the Fed’s target. Consumer five-year inflation expectations have been on the rise since 2020 and are breaking out to new highs, as this next chart shows.

Source: University of Michigan

The Fed Is Likely To Hike Rates Again 

With their favorite inflation gauge accelerating and consumer inflation expectations on the rise, it seems highly likely that the Fed will keep hiking interest rates — if they are really serious about helping consumers by “fighting” the inflation they created. 

Indeed, the market is now estimating 65% odds of a rate hike at the next Fed meeting in mid-June and no rate cuts until November.

As shown in the chart below, the Fed has historically raised the Federal Funds Rate (red line) above both Sticky Price CPI less Food and Energy (blue line) and Core CPI less Food and Energy (green line) before cutting rates.

Sticky Price CPI less Food and Energy of 6.3% and Core CPI less Food and Energy of 5.5% both remain above the Fed Funds rate target of 5%-5.25%. And these inflation gauges exclude food. Food inflation increased a whopping 7.7% in April. That is a significant hardship for consumers, which is why inflation is an important political issue that pressures the Fed to raise rates further.

Are Rate Hikes Or Rate Cuts Bullish?

Additional Fed rate hikes will put even more pressure on the economy, which is already struggling with the inverted yield curve, declining money supply, ongoing banking crisis, rising unemployment claims and leading economic indicators at recessionary levels. Further rate hikes are likely to be bearish for stock prices.

Of course, most investors are hoping the Fed pauses rate hikes or cuts rates soon. But with inflation remaining well above their targets, that is only likely to happen if there are very serious problems in the banking system or economy. Thus, rate cuts would also likely be bearish for stock prices.

Until inflation starts slowing rapidly toward the Fed’s 2% target, Jay “Softish Landing” Powell will face the biggest challenge of his career. Given his track record as one of the worst Fed Chairs in recent history, whatever decisions he makes are likely to be bearish for stocks and other risk assets.