PCE: Topline Inflation Cooling, Core Staying Sticky

Today’s PCE inflation data release continues to illustrate a familiar trend trend: inflation cooling at the topline while the core measure remains sticky. Here’s what you need to know.

Inflation Cooling at the Topline

The headline PCE inflation, which includes all items, continues to slow, falling from 4.3 percent year-over-year in April 2023 to 3.4 percent in May 2023​​. This decrease is largely attributed to falling energy prices and slower food price increases, reflecting less pressure from gasoline but also food prices​​.

Headline PCE also rose month-over-month, but only by a modest 0.1%, less than the 0.4% we saw during April as energy prices fell in May.

The market rallied higher on the release, with the S&P 500 trading at 4455, up 1.34% on the day as of writing this article. Underneath the surface of the index we can see a rally on widening breadth, with the exception of the real estate sector and some noteworthy underperformers like NKE, MU, and SCHW.

Core Inflation Remains Sticky

In contrast, core inflation, which excludes food and energy, remained sticky at 4.6 percent year-over-year. This measure has been in a tight range of 4.6 to 4.7 percent year-over-year for the last six months.

A significant contributing factor to the persistent core inflation is stubborn services prices, particularly housing costs in the form of rents, which tend to lag new and existing home prices by about 18 months​.

Implications for the Economy

Despite the slower overall real spending, much of the spending was on services, contributing to the stickiness of core PCE inflation. This data supports the Federal Reserve's desire to continue raising interest rates to return inflation back to the 2-percent target​​. Fed Funds Futures are currently pricing in 86.8% odds of a 25 bps hike at the July 26th meeting.

Consumer Spending and Income Trends

Consumer spending is showing signs of slowing, particularly on goods. Real spending was unchanged in May 2023, signaling slower momentum in the second quarter of 2023 following the first quarter's surge​.

Services spending continued to increase in nominal terms, particularly in health care, other services, transportation, housing and utilities, financial services and insurance, as well as food services and accommodations.

Goods spending fell significantly on gasoline, other energy goods, motor vehicles and auto parts. There was also a small drop in recreation services.

Nominal personal income rose in May, and real incomes continued to rise year-over-year, supporting continued spending by U.S consumers​.

Federal Reserve Policy Outlook

Fed Funds Futures are now pricing in a 25 bps cut as early as March, with another in May.

Just yesterday the first cut was priced for May, but with today’s data expectations are shifting. The market also does not believe the Fed will hike twice more, capping out the last hike of the cycle in July for 25 bps to get to a policy range of 5.25 - 5.50%.

We continue to feel there’s room for a hike in July and potentially at least one more after that later in 2023.