The Fed’s New Key Inflation Rate Rose In Q4, But S&P 500 Rallies

The Fed’s favorite inflation rate, the core PCE price index, eased to a 3.85% annual rate in Q4, new data released with GDP figures showed on Thursday. While the monthly PCE inflation data out on Friday at 8:30 a.m. ET will get closer scrutiny, the easing of core prices on a quarterly basis hinted that no major unwelcome surprises are waiting. That helped lift the S&P 500 to its highest level since the last Fed meeting in Thursday stock market action.

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Wall Street expects Friday’s data to show the PCE price index was flat in December, as the annual inflation rate slowed to 5% from 5.5%. Core PCE prices are seen rising 0.3%, as the core inflation rate slips to 4.4% from 4.7%.

This S&P 500 rally is built on belief that inflation will continue its steady retreat even as the U.S. economy avoids a hard landing. That could allow the Fed to pause rate hikes after quarter-point moves next Wednesday and on March 22. Markets expect Fed rate hikes to turn to rate cuts late this year.

Fed Chair Powell’s New Inflation Rate

That bullish scenario seemed to get support from the Q4 PCE inflation data. However, it may be too soon to celebrate. That’s because Fed Chair Jerome Powell has tried to shift the focus of policymakers and investors to a new key inflation rate: PCE services excluding energy and housing.

That category, which includes health care, education, haircuts, hospitality and more, accounts for about 50% of consumption. Powell has called it “the most important category for understanding the future evolution of core inflation.” That’s because price changes for such services are closely tied to wage growth. If the labor market remains extremely tight, high services inflation may persist.

So what did Q4 PCE data show? The news wasn’t great: The price index for core PCE services minus housing rose at a 4.7% annualized rate in Q4. The inflation rate for core PCE services minus housing over the past 12 months picked up to 4.4% from 4.2%.

The data may come as a bit of a surprise. When CPI data came out on Jan. 12, a number of analysts pointed out good news for Powell’s focus on inflation in services excluding shelter. That CPI measure showed prices in this category diving to a tepid 1.2% annualized rate in Q4.

Yet that underscores the huge differences in the way the government measures PCE inflation and CPI inflation.

PCE Vs. CPI Inflation

The PCE covers a much broader range of spending than the CPI, which only reflects out-of-pocket spending. The distinction matters, especially when it comes to health care. Employers and the government pay a huge share of medical bills, which the CPI ignores. While medical care services make up only 7% of the CPI’s basket of household purchases, health care services account for nearly 16% of PCE.

Not only that, but the CPI’s medical services inflation gauge began falling rapidly in October. That drop should continue, but it’s not really indicative of current pricing. It reflects insurer profits reported last fall.

Among numerous other differences, Powell’s new PCE services inflation measure also includes dining out. However, CPI data groups food away from home with goods, not services.

What Does This Mean For S&P 500?

If Powell’s “most important” inflation rate continued to be elevated in Q4, why is the S&P 500 rallying?

That may be partly due to earnings, with Tesla (TSLA) getting a notable pop. It’s also possible that investors aren’t paying much attention to Powell’s new category of inflation.

The focus on core PCE services minus housing is so new that it isn’t provided in Commerce Department’s report or a subject of Wall Street estimates. IBD’s calculations to derive the quarterly data in this article and the monthly data in the accompanying chart require a multistep process.

Persistent inflation in Powell’s services category could keep Fed policy tighter for longer, but that’s far from clear. The real key to inflation and Fed policy is wage growth. December’s jobs report showed wage growth cooling to a 4% annual rate in Q4. That’s not too far above the 3.5% wage growth that Powell has said could be consistent with the Fed’s 2% inflation target.

If moderation in wage growth continues, the Fed can be more patient in waiting for inflation to subside. Two big reports on wage growth next week loom large: Tuesday’s Q4 Employment Cost Index and Friday’s January jobs report.

Meanwhile, the S&P 500 is staying in rally mode, rising 0.6% in Thursday afternoon trading. After trading on either side of its 200-day line over the past two weeks, the S&P 500 has now pushed to its highest level since Dec. 14. This is a key juncture. The S&P 500’s past few tries to leave behind its 200-day line were quickly turned back.

As of Wednesday’s close, the S&P 500 was 16.3% below its record closing high, but up 12.3% from its bear-market closing low on Oct. 12.

Be sure to read IBD’s The Big Picture each day to stay in sync with the market’s underlying trend and what it means for your trading decisions.

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