Lower May-24 PCE inflation may finally make Fed rate cut a reality

1 Jul 2024 , 10:35 AM

AFTER GDP; EVEN PCE INFLATION DATA FAVOURS RATE CUTS

The PCE inflation is a key data point for the US economy. Unlike the Consumer Inflation reported in the middle of each month, the PCE inflation reports prices from the perspective of consumer spending. Hence, from a policy perspective, PCE inflation gives a much better picture of the price situation. That is why, the US Fed uses PCE inflation as the benchmark for making its rate decisions. However, it has been historically observed that the consumer inflation and the PCE inflation tend to converge in the same direction. The Fed has been internally debating about the right time to start rate cuts. Now, the Fed has two data points in two days that signal that the time may be ripe for the Fed to cut rates. Here is why!

The third and final estimate of Q1-2024 GDP was published by the US Bureau of Economic Analysis (BEA), just a day prior to the announcement of the PCE inflation. The final estimate pegged the GDP growth for Q1-2024 at 1.4%. That is sharply lower than the 3.4% achieved in Q4-2023 and 4.9% achieved in Q3-2023. Clearly, the sustained hawkishness of the Fed (in words and action) has had its impact on the GDP growth. More importantly, the lower GDP growth has been led down by a sharp fall in consumption demand. The Fed also felt that if the GDP growth was too high, then it would be hard to achieve 2% inflation. Now, the GDP growth has toned down and looks more in sync with the 2% inflation target. Secondly, the PCE inflation for May 2024 has also come in lower at 2.6%. Had it not been for the oil price spike globally, the actual PCE inflation would have been closer to 2%; but that is a subject matter for debate in a different forum altogether. The message for the Fed is that; the lower GDP growth and the lower PCE inflation are now making a strong case for a rate cut.

PCE HEADLINE INFLATION VERSUS PCE CORE INFLATION

The good news is that PCE inflation and the PCE core inflation are is still distinctively lower from a longer term perspective. We have considered 9-months of data in the table below from September 2023 to May 2024. While the headline inflation has dropped by 80 bps in this period, the core inflation has fallen by 100 bps in the same period. It appears to be a case of unwinding of the supply chain constraints post the pandemic, still continuing.

Month	Headline PCE Inflation	Core PCE Inflation
September 2023	3.4%	3.6%
October 2023	2.9%	3.4%
November  2023	2.7%	3.2%
December 2023	2.6%	2.9%
January 2024	2.4%	2.9%
February 2024	2.5%	2.8%
March 2024	2.7%	2.8%
April 2024	2.7%	2.8%
May 2024	2.6%	2.6%

Data Source: Bureau of Economic Analysis (US)

If you look at the above table, both headline PCE inflation and core PCE inflation have been progressively lower. That trend had briefly halted in the last 3 months; although it must be said that May 2024 has shown a return to the falling inflation trend. The trend in recent months has been that, while core inflation and food inflation have been flat to lower, the villain of the piece has been energy inflation. For instance, between January 2024 and May 2024, the energy inflation has progressively spiked from -4.9% to +4.8%; contributing to most of the pressure on the headline PCE inflation. For the PCE inflation to make a convincing dash for the 2% mark, it is essential that the energy inflation comes under control. For that, the Red Sea imbroglio needs to be resolved. At this juncture, no solution appears to be in the horizon; at least not till Israel continues its aggression in the Gaza Strip.

PERSONAL INCOME STORY FOR MAY 2024?

PCE inflation is relevant in 2 ways. Firstly, since it is announced at the end of the month, it includes more data points than consumer inflation. Secondly, PCE inflation reflects  prices from a personal consumption expenditure (PCE) perspective. That explains why the US Fed uses PCE inflation as the benchmark for rate action. Here are key May 2024 data points.

• Personal income in May 2024 increased by $114.1 Billion (0.5% monthly) as per the estimates put out by the US Bureau of Economic Analysis (BEA).
• Disposable personal income (DPI), personal income minus personal taxes, increased $94.0 Billion (0.5%) while personal consumption expenditures (PCE) increased by $47.8 Billion (0.2%). Compared to last month, the DPI and the PCE have been stable.
• The increase in current-dollar personal income in May 2024 primarily reflected increases in compensation, personal income receipts on assets, and government social benefits to individuals.
• Let us turn to the positive drivers of $47.8 Billion increase in personal consumption expenditure for May 2024. There was an increase of $34.2 Billion in spending for services and an increase of $13.6 Billion spending for goods.
• Within services, the largest contributors to the spike were healthcare (led by hospitals), housing and utilities (led by housing), and transportation services (led by air transport).
• Within goods, the leading contributor to the increase were spending on non-durable goods (led by prescription drugs), which was partially offset by gasoline and other energy goods.
• Personal savings were higher at $806.1 Billion in May 2024 and the ratio of personal savings to disposable personal income increased by 30 bps to 3.9%.

The broad message is that the US people are getting a little more cautious about spending and that is a good sign as it could now rein in the consumption driven inflation.

BREAK-UP OF US PCE INFLATION (YOY) FOR MAY 2024

The US Bureau of Economic Analysis (BEA) publishes the PCE inflation on a yoy basis and on MOM basis. Let us first look at the PCE inflation on a yoy basis with granular break-up.

Break-up of PCE Inflation (YOY)	Oct-23	Nov-23	Dec-23	Jan-24	Feb-24	Mar-24	Apr-24	May-24
Headline PCE Inflation (Year on Year)	2.9	2.7	2.6	2.5	2.5	2.7	2.7	2.6
Goods	0.2	-0.1	0.2	-0.5	-0.2	0.1	0.1	-0.1
Durable goods	-2.2	-2.1	-2.3	-2.4	-2.0	-1.9	-2.2	-3.2
Nondurable goods	1.6	1.0	1.6	0.5	0.8	1.3	1.4	1.6
Services	4.3	4.1	3.9	4.0	3.9	4.0	4.0	3.9
Addenda:
Core PCE excluding food and energy	3.4	3.2	2.9	2.9	2.8	2.8	2.8	2.6
Food	2.4	1.7	1.4	1.4	1.3	1.5	1.3	1.2
Energy goods and services	-4.6	-5.0	-1.7	-4.9	-2.3	2.6	3.0	4.8

Data Source: US Bureau of Economic Analysis (BEA)

The above table classifies yoy PCE inflation into goods and services inflation; and also breaks up inflation into food, energy, and core inflation. Here are major takeaways.

• Headline PCE inflation has shown a secular downward trend since April 2023. Between October 2023 and May 2024, the PCE inflation has fallen a full 30 bps to 2.6%.
• PCE inflation for goods turned negative in May 2024 at -0.1%, after a gap of 3 months. Within goods, the durable goods dipped deeper into negative from -2.2% to -3.2% while the inflation in non-durable goods hardened from 1.4% to 1.6%. This can be explained by the supply chain constraints and delivery delays caused by the Red Sea crisis.
• For May 2024, the services inflation tapered by 10 bps from 4.0% to 3.9%. However, the April 2024 services inflation had been upped by 10 bps, so net impact is Nil. Incidentally, the services inflation is down a full 170 bps from a high of 5.6% in April 2023.
• Core PCE inflation yoy has shown a consistent downtrend from June 2023 till February 2024; falling 150 bps from 4.3% to 2.8%. However, since February 2024, the core PCE inflation has stagnated at 2.8%; although May 2024 showed a sharp fall to 2.6%.
• On a yoy basis, PCE food inflation is 10 bps lower at 1.2%, but is sharply down by 350 basis points from 4.7% in June 2023. In calendar 2024, March was the only month that saw a sudden spike in food inflation.
• Energy inflation continues to be the crux of the inflation problem in the US, largely on account of the Red Sea crisis putting global trade off track. Between January 2024 and May 2024, the PCE energy inflation has spiked from -4.9% to +4.8% (a spike of 970 bps). Energy inflation is the one factor that is holding back headline inflation from 2% target.

To sum up, energy inflation continues to remain the weak link. With the situation in the Middle East and West Asia remaining intractable, it could take longer than expected.

BREAK-UP OF US PCE INFLATION (MOM) FOR MAY 2024

The table below captures the high frequency month-on-month (MOM) inflation published by the US Bureau of Economic Analysis (BEA), capturing short term trends.

Break-up of PCE Inflation (MOM)	Oct-23	Nov-23	Dec-23	Jan-24	Feb-24	Mar-24	Apr-24	May-24
Headline PCE Inflation (MOM)	0.0	0.0	0.1	0.4	0.3	0.3	0.3	0.0
Goods	-0.3	-0.6	-0.2	-0.2	0.5	0.1	0.2	-0.4
Durable goods	-0.2	-0.5	-0.5	0.2	0.2	0.1	-0.2	-0.8
Nondurable goods	-0.3	-0.6	-0.1	-0.4	0.7	0.2	0.5	-0.2
Services	0.2	0.3	0.3	0.7	0.2	0.4	0.3	0.2
Addenda:
Core PCE ex-(food and energy)	0.1	0.1	0.2	0.5	0.3	0.3	0.3	0.1
Food	0.2	-0.1	0.0	0.5	0.1	0.0	-0.2	0.1
Energy goods and services	-2.5	-1.9	-0.3	-1.4	2.3	1.2	1.2	-2.1

Data Source: US Bureau of Economic Analysis (BEA)

Like the YOY inflation, even the MOM PCE inflation data is classified into goods and services inflation as well as food, fuel, and core inflation. Here are key takeaways.

• After being elevated in the range of 0.3% to 0.4% in the last 4 months, the MOM inflation fell back to 0.0% in May 2024. That is a good sign and indicates that the short term pressures on inflation, or the high frequency pressures are reducing.
• MOM PCE inflation for goods had fallen sharply from 0.2% to -0.4% in May 2024. The durable goods inflation fell further from -0.2% to -0.8%, while non-durables inflation also fell sharply from 0.5% to -0.2%.
• Services inflation MOM edged lower from 0.3% in April 2024 to 0.2% in May 2024; a macro indication that the short term pressures are easing across the board.
• High frequency Core PCE inflation was lower at 0.1% in May 2024, while MOM food inflation spiked from -0.2% to 0.1%. However, the good news came from energy inflation which fell sharply from 1.2% to -2.1% on the high frequency indicator.

If the Fed has been worried about last mile inflation, then May is the first decisive signal that the inflation pressures are easing across key parameters. That is the good news!

FED MAY VENTURE INTO RATE CUTS SOON

The combination of the GDP data and the PCE inflation should give the Fed the requisite confidence to cut rates, a full one year after the rate hike cycle topped out. Here are the CME Fedwatch probabilities after the PCE inflation data.

Fed Meet	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525	525-550	550-575
Jul-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	10.3%	89.7%	Nil
Sep-24	Nil	Nil	Nil	Nil	Nil	Nil	6.2%	57.9%	35.9%	Nil
Nov-24	Nil	Nil	Nil	Nil	Nil	2.2%	24.2%	50.3%	23.4%	Nil
Dec-24	Nil	Nil	Nil	Nil	1.6%	18.4%	43.4%	30.5%	6.2%	Nil
Jan-25	Nil	Nil	Nil	0.9%	11.3%	32.8%	36.0%	16.5%	2.6%	Nil
Mar-25	Nil	Nil	0.6%	7.6%	25.1%	34.8%	23.4%	7.5%	0.9%	Nil
Apr-25	Nil	0.3%	3.8%	15.6%	29.6%	29.6%	16.2%	4.5%	0.5%	Nil
Jun-25	0.2%	2.4%	10.8%	23.9%	29.6%	21.6%	9.2%	2.1%	0.2%	Nil
Jul-25	1.1%	5.4%	15.6%	26.0%	26.7%	17.1%	6.6%	1.4%	0.1%	Nil

Data source: CME Fedwatch

The Fed Futures market has been enthusiastic about rate cuts for quite some time now, and the latest GDP and PCE inflation data have made the first rate cut more likely in September, or, perhaps, even a pre-emptive rate cut on July 31st, 2024.

• The probability of the first rate cut happening in September 2024 is up to 64%; although the chances of a rate cut on July 31, 2024 is only 10% for now.
• What about the situation at the end of 2024? By December 2024, there is a 63% probability of 2 rate cuts. This could spike if the Fed implements the first rate cut in July itself, and even open up the possibility of 3 rate cuts in 2024.
• What about the situation by mid-2025? By July 2025, there is a 75% probability that there would be 3 rate cuts while there is a strong 48% probability of 4 rate cuts. That is constant over last month.

The latest data on GDP and PCE inflation raises the probability of a rate cut in September; and even opens up the possibility of the Fed pre-emptively cutting rates on July 31, 2024.