In my Forecasts & Trends on Tuesday, I pointed out the importance of Federal Reserve Chairman Jerome Powell’s suggestion last week that the Fed Funds rate might not have to rise nearly as much next year as the markets have been expecting. US stocks rallied strongly on this news late last week.
As regular readers will recall, the markets have been expecting another 0.25% rise in the Fed Funds rate on December 19, to be followed by 3-4 additional 0.25% rate hikes in 2019. Most Fed-watchers still expect we will get the rate hike on December 19, despite the latest freefall in the stock markets. Yet Powell’s comments last week suggested the Fed might take a pause before raising the rate further next year.
Most Fed-watchers are now thinking that maybe we will only get 1-2 rate hikes next year instead of 3-4. My question is, what has changed to bring about this significant reversal in the Fed’s thinking? I think I have the answer: The outlook for inflation next year has fallen significantly.
The Fed’s favorite gauge of US inflation is the Personal Consumer Expenditures Index (PCE) from the Commerce Department. As you can see below, the PCE has come down significantly in the last several months. Normally, you would expect inflation to be going up in a strong economy as we have now. Not so in recent months.
As you can see in the chart above, the rise in consumer prices slowed significantly in the three months ended in October (latest data available). I firmly believe that this weakening in the Fed’s favorite inflation index led to Chairman Powell’s change of heart on interest rates last week. Let’s take a look at a few “internals” from this latest report on PCE.
1. PCE Index October: While the labor market continues to tighten and wage gains are picking up, price inflation remains subdued according to the most currently available data. For starters, the core PCE rose only 1.8% in the 12 months ended October, the lowest such pace since February. As was the case in September and August, that was well below expectations.
2. Cost of Consumer Goods. The core PCE (less food and energy) for consumer goods fell -0.6% year-over-year (y/y) during October. On the other hand, the US import price index excluding energy has been moving higher since early 2017 after falling the previous two years. Yet it was up only 0.7% y/y during October, also below expectations.
3. Cost of Consumer Services: The PCE for services rose 2.6% y/y during October, an eight-month low. Wireless telephone services prices fell sharply during 2017, but stabilized this year. So, some of the upward pressure on inflation this year simply reflected much less deflation in this services category.
4. Cost of Housing/Rent: The rate of inflation for rent of primary residences has risen sharply during the current economic expansion, but the rate of increase has been moderating over the past two years. It was still high at +3.6% y/y during October, but the recent boom in multi-family housing construction may be closing the gap between the demand and the supply of rental housing units.
5. Cost of Medical Care: Of even greater importance may be what is happening to prices in the healthcare industry. They aren’t rising much at all. Over the past 12 months through October, the PCE for medical care is up just 1.3%, with hospital and physician services up only 1.5% and 0.7%, respectively. Surprisingly, prescription drug prices were up just 0.8% over the past year.
The moderation in the latter might reflect pressure from the Trump administration on drug companies to keep a lid on their prices. The services components of healthcare may finally be experiencing long-overdue upturns in their productivity, which may be a long-term phenomenon as new competitors – most notably Amazon – enter the field.
6. Energy Costs Falling: Helping to moderate inflationary expectations has been the recent 30+% plunge in the price of crude oil since early October. Technological innovation continues to disrupt the global oil industry, as US frackers are now producing record amounts. US crude oil exports have doubled since mid-January 2015 to 7.4 million barrels per day.
Conclusions: I could go on with examples, but the point is the Fed’s favorite barometer of inflation has come down significantly in the last few months as of the end of October. This answers my question about what has changed to make the Fed consider altering its policy that interest rates should continue to climb significantly higher.
I don’t believe this news is fully reflected in the current stock market pricing, especially in light of the dramatic plunge in stock prices over the last two market days. So, there is some good news out there which may help – if President Trump can keep his (“I’m a tariff man”) mouth shut.
I better leave it there for today.
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