What does the Fed’s preferred inflation gauge suggest about U.S. price increases?

Executive summary:

The U.S. core PCE price index rose 0.4% in January, in line with consensus expectations
Markets anticipate that Federal Reserve rate cuts could begin by the middle of the year
The U.S. avoided a partial government shutdown after Congress passed a short-term funding bill

On the latest edition of Market Week in Review, Director of Investment Strategies, Shailesh Kshatriya, and Sophie Antal-Gilbert, Head of AIS Portfolio & Business Consulting, discussed recent U.S. inflation data as well as the stopgap funding measure passed by the U.S. Congress to avert a government shutdown.

U.S. PCE price index climbs 0.4%, matching consensus estimates

Antal-Gilbert and Kshatriya opened the segment by unpacking the January reading of the U.S. core personal consumption expenditures (PCE) price index the U.S. Federal Reserve (Fed)'s preferred inflation gauge. Kshatriya said that core prices rose 0.4% on a month-over-month basis and 2.8% on a year-over-year basis, matching consensus expectations.

"At first glance, this looks like good news but there is a slight wrinkle to the story," Kshatriya remarked. He noted that the monthly increase of 0.4% was greater than December's 0.1% gain and marked the largest increase in the index since January 2023. This helped pull the six-month annualised core inflation rate to 2.5%, versus December's reading of 1.9%, he said.

"This new number marks a reacceleration in inflation, and is also obviously above the Fed's target rate of 2%," Kshatriya stated. While characterising the January PCE reading as perhaps a slight setback, he stressed that overall, the U.S. inflation story has generally been positive, with a considerable amount of disinflation taking place in the past year. "One month of data doesn't necessarily change the broader picture, which is that inflation is on a downward trend," Kshatriya remarked.

As for how the latest report could impact the Fed's timeline for cutting rates, he said the central bank understands that month-to-month data can be volatile and will continue to exercise patience. Kshatriya pointed out that New York Fed President John Williams said as much in recent remarks, stating that restoring price stability will require time but that if the data continues to trend in a favourable direction, the three rate cuts pencilled in at the Fed's December meeting still look reasonable.

"Markets are pricing in this idea, with investors betting that the Fed starts lowering rates sometime in the middle of this year," Kshatriya noted, adding that he generally agrees with this viewpoint as long as inflation continues to decline and the labour market continues to rebalance.

U.S. Congress passes short-term funding bill to avert government shutdown

Antal-Gilbert and Kshatriya shifted gears to the latest developments from Washington, D.C., where a partial U.S. government shutdown was averted after the House of Representatives and the Senate passed a temporary spending bill on 29 February. The measure buys Congress a little more time to finalise a full-year funding bill, Kshatriya said, noting that the more consequential deadline for lawmakers to come to an agreement on funding has been extended to 22 March.

"This is yet another example of the government kicking the can down the road a bit, but it does sound like Congress could be potentially close to a deal on securing funding through the end of September. Some reports suggests lawmakers just need to iron out the details, so hopefully they'll be able to take advantage of the extra time to flush out their differences," Kshatriya stated.

He noted this isn't the first time Congress hasn't met a budget deadline, with U.S. lawmakers repeatedly missing deadlines ever since the 1990s. "Temporary spending measures like the one just passed have become par for the course in the U.S. in recent decades. What's more, government shutdowns which the U.S. thankfully averted this time around aren't anything new, with six shutdowns occurring since 1990," Kshatriya observed.

He added that investors tend to look through government shutdowns, with market returns in the past six shutdowns generally positive. This is because whatever economic output is lost during a government closure is subsequently recouped in the months after the shutdown ends, Kshatriya explained. "Ultimately, when it comes to government shutdowns, investors are best served by staying disciplined and sticking to their plans," he concluded.

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Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.