PCE Inflation Is Approaching the Fed’s Target

• The Cleveland Fed endorsed March PCE growth of 0%.
• The outcome would drop annualized growth to 2.1%.
• That would mean the Fed has 230 basis points worth of rate-cut potential.

The Federal Reserve’s preferred inflation gauge is on the verge of hitting its 2% target…

This coming Wednesday brings the next key update on price growth. The U.S. Bureau of Economic Analysis (“BEA”) releases personal consumption expenditures (“PCE”) data for March. We care about the update because our central bank uses this index when making monetary policy decisions.

You see the Fed feels PCE is a more complete inflation reading because it measures the total spending on goods and services consumed by individuals, including those bought on their behalf like health insurance. On the other hand, the U.S. Bureau of Labor Statistics’ consumer price index (“CPI”) focuses on out-of-pocket spending by urban consumers.

Consequently, the individual weights within PCE tend to be less concentrated than CPI. That means PCE fluctuates less, driving the Fed’s preference. And as you can see in the following chart, since peaking in mid-2022, the pace of increase has been steadily dropping…

Growth in services prices keeps easing, according to recent business surveys. The change should have a greater influence on PCE compared to CPI. And based on the numbers I surveyed, the Fed’s preferred inflation gauge saw subdued growth in March. That will support the case for easier monetary policy from our central bank later this year. And it would underpin a steady long-term rally in the S&P 500 Index.

But don’t take my word for it, let’s look at what the data’s telling us…

Two weeks ago, BLS released its consumer and producer price index data for March. Within those gauges are a number of readings we care about as it relates to PCE. According to the data, items like housing, financial services and insurance, and health care rose. Yet others, like food & accommodation, as well as transportation contracted.

Housing and medical expenses account for roughly 17% of the PCE index each while the other categories’ weightings range between 3 and 8%. I ran the BLS inputs against the relative PCE weightings. Based on the numbers, it appears the pace of growth eased in February compared to January.

Confirming this are the Inflation Nowcast numbers from the Federal Reserve Bank of Cleveland. Its economic staff continually updates its outlook based on the most recent economic data. According to the forecast, the pace of PCE growth fell to breakeven in March compared to the 0.3% increase in February.

So, let’s see what that means for the pace of annualized growth…

The above table details the pace of monthly PCE growth for the last year. But to get an idea of what the annualized pace could look like when the numbers come out at the end of this week, I dropped the data from last March and incorporated the forecast for this year from the Cleveland Fed. As you can see, 0% monthly growth would drop the annualized numbers to just 2.1%. Yet, it is worth noting that Federal Reserve Chairman Jerome Powell suggested two weeks ago that the number could come in around 2.3%.

There’s an important shift taking place that we should be keeping an eye on. At the start of 2024, we experienced “hot” monthly PCE growth. January through April represented more than half of the 2.5% annualized number from the end of last year. So, anything weaker than last year’s result would mean the pace of growth should keep slowing.

As Powell has said recently, it’s still too early for the central bank to look through the inflation potential from tariffs. It needs more time to see how the policy implementation affects prices. Yet, based on the numbers from February, and the early indication for March, growth is easing. And when we subtract the March PCE forecast of 2.1% from the effective federal funds rate of 4.4%, it tells us our central bank would have 230 basis points of rate-cut potential.

So, as I said at the start, when PCE numbers are released on Wednesday, they’re likely to show the pace of monthly growth eased. Such an outcome should allow the Fed to pursue a normalization of monetary policy, supporting steady economic growth and a long-term rally in the S&P 500 Index.

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