Inflation, with all the trimmings

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Today’s personal income and spending report confirmed a resilient consumer and sticky high inflation. Consumption was on consensus, rising 0.4%. However, personal income rose 0.6% or double the consensus forecast. There are also signs that the saving rate is starting to stabilize at just above 4%. If healthy consumption growth is no longer being sustained by dipping into savings, this could be another sign of resilience. This suggests that the Fed does not need to be in a rush to cut rates.

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On the inflation front, as usual the main focus was on the core PCE deflator, which rose a solid 0.3% on the month. The good news is that it was a “soft” 0.3%, with a two digit increase of 0.27%. The bad news was that this still means a 3.32 annualized increase, well above the 2% target.

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Of course, the core is a relic of the 1970s when commodity shocks were the main source of inflation volatility. The chart below includes two modern measures of core inflation, the median or middle of the distribution and the trimmed mean that takes out all the most volatile components rather than arbitrarily removing all food and energy. Based on these metrics, underlying inflation was very high at the start of the year, seemed to converge to target in the middle of the year and now has moved higher again. Clearly it is too early for the Fed to declare “mission accomplished” in its war against inflation.

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I don’t think either the growth resilience or the stickiness of inflation is a surprise. As I’ve noted many times, despite the Fed’s allegedly tight policy, real growth is being buoyed by easy financial conditions. The resulting “output gap”—with GDP running above potential—is supporting inflation. Other sources of inflation pressure include a shortage of shelter rentals, and a modest increase in inflation expectations relative to the pre-COVID level. The chart below ?shows the evolution of the median FOMC forecast for core PCE inflation. The FOMC has been gradually accepting that there will be some degree of stickiness.

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Cutting the difference in half

A few months ago my Fed call was well out of the consensus, but with market repricing my call is getting a lot less interesting, albeit still hawkish. The CME FedWatch tool shows a 66% probably of a cut in December and 34% chance of no change. I would reverse those probabilities. The market also sees the funds rate dropping to a low of 3.75-4.00%; my baseline call is for a low or 4.00-4.25%.

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The consensus views of economists are a bit more dovish. According to a Reuters poll last week, the median forecaster expects a 25 bp cut in December and cuts in each of the first three quarters of next year, putting the fed funds rate at 3.50%-3.75% by the end of next year. That is 50 bp higher than the prior poll, but still 50bp below my call.

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After Thanksgiving the next big release is the jobs report on December 6th. Recent labor market indicators look healthy, including today’s jobless claims data. Unless the jobs report is a “real turkey,” I think the Fed pauses at its December 17-18 meeting. After that all the focus shifts to potentially big shocks to aggregate supply and demand from Trump’s economic agenda. We may be in the eye of Hurricane Donald or it could be a tropical storm.

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