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Fed’s Preferred Inflation Metric: When to Cut?

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Later today sees the release of the US PCE price index, which is closely tracked by the Fed. The regulatory agency reportedly uses this measure even more than core CPI to make policy decisions. And since this is the last time the figure is published before the FOMC meets next month, investors are going to be keenly interested to see what happens.

The market and the Fed are still at odds about the future rate of policy. So far, the market has been wrong, and the Fed has pushed through with higher rates. But that could change, since the Fed is easing up on its rate hike talk, and the market could finally be vindicated with no more rate hikes. The issue is whether that translates into cuts starting in May.

What to Look Out For

The monthly core PCE Price Index for October is expected to remain unchanged at 0.3%. That would mean the core annual rate could come down to 3.5% from 3.7% previously. Naturally, that’s still above the Fed’s 2.0% target. The unchanged monthly figure might lead to the expectation that the FOMC will leave its outlook the same at the coming meeting.

For how the dollar index might react, a rise in the monthly figure – even if the annual goes down – would likely get investors more worried the Fed won’t let up. However, a miss on the figure likely would just play into the narrative that many investors already have in place. That is, they expect rates to come down sooner than the Fed says. Therefore, the surprise would likely be less pronounced.

A New “Quiet” Target?

A wrinkle in the projections is that some economists suspect the Fed might not go all the way on inflation. This has led to some talk about the Fed “quiet quitting” at, or just below, 3.0%. Prior to the latest spike in inflation, the Fed had talked about “tolerating” inflation that high. The 2.0% has been around for decades, but it is not set in stone.

There are several reasons why the Fed might want to allow a higher inflation rate, if only for a while. It would mean that the rate of tightening could be slowed down, and provide more breathing room for the economy. If there is a recession, the Fed won’t want to be blamed for it. Especially not in an election year, which typically sees the economy performing better.

There Might be no Choice

Not that the Fed would make such a view public. The going theory on monetary policy used by the Fed is that it’s expectations that drive inflation. So by insisting on targeting 2.0%, the expectations are maintained, allowing for the unofficial “quiet” easing up of conditions. But, whether or not the Fed makes it official, it would still likely weaken the dollar.

The issue is that the government continues to run a high deficit and needs to access money markets to fund its debt. The Fed concurrently draining $90B a month has contributed to higher yields, which is a problem for funding further (deficit) spending. Higher inflation has the advantage of reducing the real debt, as well as allowing yields to fall. With core PCE inching closer to the 3.0% level, we might soon find out whether this theory holds up.

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