Core inflation remains high

Inflation data released yesterday showed broad-based inflation, as measured by CPI, steadily on the decline, falling to 5% annualized from 6% in February. Given the sharp drop month-over-month, it’s likely credit constraints stemming from the March banking crisis, contributed to the contraction.

Taking out food and energy, two volatile components of CPI, and narrowing in on a measure called “core PCE”, the picture was slightly different. Core PCE actually rose in March to 5.6% annualized from 5.5% the month prior. While a 0.1 point increase isn’t statistically significant, the bigger idea to focus on is the stickiness of this data point in the context of the Fed’s tightening cycle. Since Dec’ 22, core PCE has basically not budged despite multiple restrictive efforts by the Fed, including rate hikes totaling 0.5% and rolling off a sizeable portion of their balance sheet via QT. Zooming out even further, a year ago core PCE stood at 6.2%. In 12 months, after 4.5% of Fed Funds increases, core PCE has only dropped 0.6 points. In contrast, the broad inflation reading of CPI is down 3.3 points over the same period, namely from a significant drop in energy prices.

While headline inflation readings paint a rosy picture for politics and other determined to take the win over inflation, core PCE will remain the Fed’s primary concern. So far, the intended downward direction hasn’t materialized against a multitude of aggressive rate hikes implemented over the past year. The Fed’s other favorite indicator, unemployment, remains stubbornly low. At 3.5% in March ‘23, the reading is only down 0.1 points from 3.6% in Feb ‘23 and actually up from the Jan ‘23 reading of 3.4%. The Fed has publicized it’s intentions to see unemployment rise to 4.5%, a magnitude of job destruction never seen without a recession. Combined, inflation is still a mile off the Fed’s target of 2% and unemployment is nowhere near the levels the Fed thinks will sustain effective inflation reduction.

In March ‘23, we saw the banking system start to crack with the 2 of the 3 biggest bank failures in US history (read again, HISTORY). Emergency gov’t lending programs calmed the storm, yet the Fed still took rates higher. Ironically, higher rates, and subsequent deposits runs towards higher-yielding money market funds, was the exact reason for the bank blow-ups in the first place. Clearly, inflation was top of mind for the Fed to run policy counter to such an obvious truth.

At this point, the Fed isn’t likely done with rate hikes. Persistently hot core PCE and unemployment readings tells us why. May and June ‘23 Fed meetings with be pivotal events to see how fast we accelerate towards a widely anticipated recession in the back half of the year. In some ways, it feels like the Fed got lucky the failures of SVB and Signature Bank didn’t turn into wide-spread financial system panic. And like the gambler at the craps table who can’t walk away from a hot hand, the Fed just tested it’s luck again by stating it’s intention to take us longer, and deeper into the rate hike cycle even if it means all hell breaks loose in the process.