Inflation Going The Wrong Way

Dan North | March 2023

Inflation is not budging – it’s going back up.

Inflation as measured by the Personal Consumption Expenditures (PCE) Price Index rose 0.6% m/m in January, driven by a hefty 2.0% m/m increase in energy prices. That drove the y/y rate the wrong way for the Fed, pushing it up to 5.4% from December’s 5.3%. The headline rate of 5.4% was driven by food and energy prices, which over the past year have risen by 11.1%, and 9.6% respectively.

Perhaps more importantly, the core PCE rate, which strips out volatile food and energy prices, rose 0.6% m/m, the highest reading in seven months, again the wrong way. That pushed the y/y rate up 0.1% to 4.7%, again the wrong way, and much higher than expectations of 4.4%. It also keeps the y/y rate hovering in the range of 5.2% to 4.6%, where it has been for 10 solid months. This must be a maddening situation for the Fed. I can just hear Chairman Powell this morning when this report was released saying, “Oh come on! Things are supposed to be going down, and they’re going up instead? Really?”

In passing, the Fed follows the PCE price index more than other measures such as the Consumer Price Index (CPI) for several reasons. First, it covers a broader scope of items. The CPI measures only what consumers spend out of pocket, whereas the PCE includes services that are paid for them by others, such as Medicare and Medicaid. Second, it takes into account consumer behavior such as switching to chicken from beef if beef prices rise too high. The PCE adjusts for this behavior once a quarter whereas the CPI makes this adjustment around every two years. Because CPI doesn’t take into account consumers’ switching to cheaper goods as quickly, it tends to run hotter than PCE. Finally, there are differences in the weights of the components. The biggest differences are that the PCE gives weight to housing of 16% versus 33% in the CPI, and PCE weights medical care at around 17% vs. the CPI’s 7%. All together the Fed thinks the PCE is a more accurate gauge of consumer inflation. Furthermore, the Fed focuses on the core rate because it can’t really control things like the avian flu, which has sent the price of eggs through the hen-house roof. Therefore stripping out food and energy prices gives a better measure of underlying inflation.

This recent report on inflation also includes important data on consumption (about 70% of all economic activity) and income. Personal Income (PI) rose only 0.6% m/m in January, far below expectations of 1.2%. However, it was still enough to drive the y/y rate up to 6.4%, the highest in 14 months. There is an important detail here though – Social Security payments, which are included in PI, got a gigantic 9.0% boost in January, the most in over 41 years. Without that huge increase, overall PI would have grown only 0.3% m/m instead of 0.6% and that would have been a much bigger disappointment.

A more meaningful measure of what consumers can actually spend is Real Disposable Personal Income (DPI) which strips out both inflation and taxes. In January Real DPI rose by 1.4% m/m to 2.8% y/y, both massive gains, again boosted by that 9% increase in Social Security payments. Both the m/m and the y/y rates were the highest since the cash injection from the American Rescue Plan (ARP) in March of 2021. 

However, just like the retail sales report, something else is unusual here too. Personal taxes dropped by a record amount of -$256 B on an annualized basis; the previous record was -$178. That obviously contributed to the 2.8% increase in real DPI. But it’s unclear where that tax cut came from – there’s not a whisper of it in the BEA’s report. And oh, does Janet Yellen know about this?

On the spending side, Real Personal Consumption Expenditures (PCE) rose 1.1% m/m, which was the highest since... you guessed it… the ARP, and in fact, it was the highest in 30 years outside of the pandemic. We know that there were seasonal adjustment issues with the retail sales report – could there be similar problems here that are overstating the gains?

The y/y rate rose to 2.4%, but that’s still less than the long-term average of 3.2%, and the trend over the past year is still down. Perhaps the 9% Social Security boost juiced both the income and consumption numbers.

So just looking at the inflation numbers, the Fed surely has the green light. But it better take a more careful look at those income and spending numbers. With the Social Security boost and the record drop in taxes, the strength of the economy is a little less clear.

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