Inflation Misses Estimates

Core PCE Below 2% Target

The all important June PCE report, which is chock full of useful economic data, was released Tuesday. In this article, I will look at the inflation section of the report. It is the most important part since the Fed is deciding whether it should have contractionary policy. To simplify this point, the Fed is deciding whether it should keep the Fed funds rate near the natural/long run rate or raise it above that rate. The natural rate is where policy neither supports, nor constricts the economy. We don’t know exactly where the natural rate is, but with the Fed funds rate coming close to the inflation rate, it seems to be getting close.

The strong GDP growth in Q2 suggests Fed policy isn’t constricting the economy at all. However, countering that point is the fiscal stimulus. Fed policy might be neutral or slightly contractionary, but it might be overwhelmed by the extremely stimulative fiscal policy. To conclude, we don’t know exactly whether the Fed funds rate is too high or too low, but the rate hikes in the medium term (next 12 months) will probably push Fed policy towards being contractionary. The positive effects from the fiscal stimulus will start wearing off in 2019. When this is combined with rate hikes, it could create a scenario where the economy weakens.

As you can see from the chart below, the PCE price index was up 2.2% year over year. I was wrong to suggest inflation would beat estimates as it missed the consensus for 2.3% inflation. The prior report was revised lower from 2.3% to 2.2%. This is good news for real wages if you use PCE inflation to deflate them. It also means the Fed shouldn’t raise rates faster. Month over month PCE inflation was only up 0.1% which met estimates and was below last month’s rate of 0.2%.

Core Inflation Decelerates

Core PCE was up 0.1% month over month which missed estimates for 0.2% and was below last month’s improvement which was also 0.2%. Furthermore, core PCE was only up 1.9% year over year which was below the consensus for 2% inflation. May’s year over year inflation was revised down from 2% to 1.9%. Technically, inflation was 1.94% in May and 1.9% in June; there was deceleration of a few basis points. Every single bout of inflation this cycle has been short lived as tough comparisons end the chances of the rate staying near the Fed’s target.

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