The Fed's Key Inflation Rate Just Heated Up; S&P 500 Falls As Rate-Hike Odds Jump

The Fed's new favorite inflation rate, which is focused on service prices, accelerated in January. This boost in inflation rates raises the odds of more rate hikes from the Federal Reserve.

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May 14, 2023 • 3 min read

In January, the Fed's preferred inflation measure of service sector prices, which is Jerome Powell’s favorite inflation indicator, accelerated. This strengthened the case for future rate increases. Consumer spending increased in 2023 and pushed the S&P below a critical support level.

PCE (personal consumption expenditures) price index increased by 0.6% in the past month, and by 5.4% compared to a year earlier. Wall Street expected a monthly increase of 0.4%. Wall Street had expected the 12-month PCE to drop to 4.9%.

The core PCE inflation rate, which excludes volatile food prices and inflation, rose by 0.6% in the last month, compared to forecasts for 0.4%. Core inflation rose to 4,7%, despite expectations that it would drop to 4.3%.

The hot readings of inflation in January were made worse by the upward revisions of December's price data, which was originally viewed as lukewarm.

Fed usually emphasizes core PCE inflation. Powell, however, has focused on the core prices of non-housing services as the key indicator for inflation. Goods prices are falling as demand returns to normal after a pandemic surge and housing costs will follow later this summer. This is because the prices of all services, from health care to haircuts, are closely tied to wages. Wages are generally the largest cost input.

Core PCE service prices excluding housing also increased 0.6% in January, the fastest rate since November 2021 and 4.65% compared to a year earlier. The annualized 3-month inflation rate jumped to 5.3%.

The December PCE report showed that Powell's non-housing core services category had an inflation rate of 4.1% over a 12-month period. It appeared at the time that the inflation pressures in the service sector had peaked. After upward revisions of December data, it is less likely that inflation will continue to decline.

The S&P 500 dropped 1.5% on Friday morning after the PCE report. The S&P 500 had largely maintained its position over the last few weeks despite rising Treasury yields and hot economic data. The S&P 500 found support so far at its 50-day average but fell below that early Friday. This could be a sign of further weakness.

The S&P 500 closed Thursday 16.35% lower than its record-breaking closing high but 12.2% higher than its bear market closing low of Oct. 12.

The yield on the 10-year Treasury note rose by 7 basis points, to 3.95%.

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The financial markets have experienced a dramatic shift in pricing since the February 3 January jobs report, which showed solid hiring and lower unemployment. Markets had expected the Fed would hike rates less than its official projections, and start cutting rates by the end of this year. The markets had 88.5% odds after Friday's PCE report that the Fed would raise its key rate by late July to a range between 5.25% and 5.5%. This implies an extra rate hike in comparison to the Fed's most recent projections.

Plus, the odds of a 50 basis-point increase on March 22 increased to 39% soon after the PCE data. A strong jobs report and more firm inflation data could push the Fed towards a half-point increase.

It may not be as bad for inflation as it seems. The wage growth seems to be slowing down, which will ease inflation in the service sector over time. The Fed may be influenced by two factors that could dictate its policy in the near term.

Fed officials are of the opinion that the costs associated with not raising rates enough to prevent inflation from becoming entrenched is much higher than the costs associated with hiking too high. Second, Fed officials have failed to convince the markets, up until fairly recently, that rates will move higher and remain there for a longer period of time. This had serious consequences. Treasury yields dropped, which helped lower borrowing costs and gave the economy a new wind.

Policymakers will not want to raise rates less than the markets expect now that markets finally listen to the Fed.