Bracing For Volatility

Macro Markets

Last month, the famous January Effect form resulted in higher inflation metrics. The Fed’s preferred inflation gauge, the annual Core PCE Index, increased to 4.7% from 4.6% in the same period, compared to analysts' 4.3%. Core PCE inflation and PCE inflation rose 0.6%. Long-term, core PCE clarifies the underlying inflation trend, removing volatility from food and energy.

PPI is a measure of average selling prices by domestic producers, serving as an early inflationary warning signal, indicating that businesses pay more for necessary inputs that produce goods ending up on retailers’ tables. In January, PPI for final demand goods rose by +1.2% monthly, while for services, PPI rose by +0.4%. Annually, PPI climbed by +6%.

We projected a higher-than-expected core PCE as we suggested in our Macro section of last week's newsletter. The shock to the upside seems on trend, with payrolls and CPI shocking. The market reaction was on expectation for a hot PCE. After a usual fakeout to the upside, we saw risk markets reprice across the board. Dollar and rates edged higher, keeping their February trend and reversing many January moves.

US consumer confidence unexpectedly declined in February as rising prices and deepening concerns about the outlook outweighed the near-term strength of the labor market. Data out Tuesday showed that the index decreased to 102.9 from a 106 reading in January. The median forecast in a Bloomberg survey of economists called for the gauge to rise to 108.5.

The decline in confidence reflects more pessimistic views on jobs, incomes and business conditions in the next six months. Inflation is proving to be stickier than anticipated, and the Federal Reserve is expected to raise interest rates higher. Higher prices erode Americans’ purchasing power, and aggressive Fed policy risks tipping the economy closer to a recession. That said, layoffs have been mainly contained to the technology and finance sectors, and the unemployment rate across the economy has fallen back to a 53-year low. The share of consumers who said jobs were “plentiful” surged to 52%, the highest since April.

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CPI vs PCE

We have been asked about PCE and CPI and their role in the market. The CPI and the PCE price index had aggressive surprises in January, primarily driven by a jump in services inflation, and services are where most consumer spending goes. But there are big differences between the two indices, including that the year-over-year increases in the PCE price index are usually lower than those of CPI. This has to do with what data the indices draw from, their weights, and how they are constructed.

Both indexes measure inflation using a specific basket of household goods and services. These baskets are similar but different across the two measures. Both measures also weigh each item in their basket roughly following its expenditure share. The more households spend on an item, like rent, the higher the weight it receives in the overall index. The weights are similar across the two indexes, but some essential differences exist.

The PCE price index has a broader scope than the CPI. The CPI is limited to expenditures that households pay out of pocket. At the same time, the PCE price index covers a more comprehensive set of goods and services as it seeks to cover prices for all consumer expenditures in the national income and product accounts. For example, the PCE price index includes prices of the health services provided to households through Medicaid, while the CPI excludes these items. The PCE price index and the CPI use different weighting systems. The PCE price index, which is more comprehensive than the CPI, estimates expenditure shares using the national income and product accounts.

Meanwhile, the CPI measures expenditure shares using a separate survey of households, the Consumer Expenditure Survey. This leads to differences in expenditure weights that can sometimes be important. You can read more about this in the reference we provided below.

The differences between CPI and PCE price indexes are essential. The FOMC has chosen to target the PCE price index because it is broader and accurately captures households' consumption. In addition, food and energy account for a significant portion of household budgets, so the Federal Reserve’s inflation objective is defined in terms of the total PCE price index. Still, the Fed monitors the core PCE price index and other inflation indicators to identify evolving inflation trends. Food and energy are volatile and don’t help give a proper trend on overall inflation, so Core is a bigger focus and market driver.

The rest of the week has no major macro events besides Fed speakers. The next market-moving event will be non-farm payrolls on March 10^th . We will write about it extensively next Wednesday.