[Premium] Core PCE: Understanding its Significance in the Market

As an important data release that can shake up financial markets, the Core PCE is a measure of inflation that market participants must pay attention to. In this article, we will explore the significance of this data and the potential implications for the market as Friday’s PCE release approaches.

Introduction

  • What is Core PCE and why is it significant?
  • How does the market respond to fluctuations in inflation?

Core PCE stands for “Core Personal Consumption Expenditures,” which is a measure of inflation in the United States. It is a variant of the Personal Consumption Expenditures (PCE) price index, which is the Federal Reserve’s preferred measure of inflation. The Core PCE index excludes volatile food and energy prices, which are subject to large and sudden fluctuations, and instead focuses on the prices of goods and services that are more stable over time. This provides a more accurate representation of underlying inflation trends and helps policymakers make informed decisions about monetary policy. PCE differs from the Consumer Price Index (CPI) in how it weights the various baskets of goods and services, and also in how PCE is revised retrospectively to reflect changes people make with their spending when inflation increases the cost of living.

CPI vs PCE Good & Service Weightings (BLS, BEA, 2022)

The main reason PCE can produce volatility in the market is that it’s a measure of inflation, which central banks use to inform their decisions surrounding interest rates. Fluctuations in interest rates will normally have a direct impact on asset valuations for both real and psychological reasons in the market. So if inflation is higher than expected, equity markets typically react badly while the dollar reacts quite positively as the market interprets the data to mean the Fed will have to be more hawkish on interest rates in the future, which is bad for equity markets. The opposite is normally true when inflation is coming in lower than expected.

Price Volatility in Bitcoin Following the March 31st PCE Release

The Role of Central Banks in Forward Guidance

  • How does forward guidance play a role in central bank decision-making?
  • What actions must the Fed take to maintain credibility in its forward guidance mandates?

The data which comes out concerning inflation all ties into the forward guidance conducted by central banks. With the Fed as the main example, they must maintain credibility through their own forward guidance mandates. This guidance refers to the fact the Fed must inform the public on what actions they are going to take with monetary policy before they take them. They also must advise the public on what data they will be responding to and what plans they have in place for certain scenarios. This means to a large degree the Fed must use inflation data like PCE to know what actions they will take next on interest rates.

US Federal Reserve Model of Monetary Policy Transmission (US Federal Reserve, 2008)

In a sense, a positive feedback loop exists now where Central banks create market instabilities through their forward guidance process. This is because among all the tools a central bank has, money supply, inflation, interest rates, QE, QT, and everything else – credibility is their greatest tool. Without credibility, a central bank cannot be effective in maintaining monetary and economic stability. This means when the Fed says they are going to do something, their hands are effectively tied and they must stick to their words otherwise their credibility is lost. As the Fed has stated to be ‘Data dependent’ many times in 2022 & 2023, it will continue to set policy based on the performance of inflation, the job market, and consumer spending.

Previous Federal Reserve Chair Greenspan’s Comments about the Feedback Loop Created from Forward Guidance (Nelson, E, 2021)

This is why we see such an avid market response to PCE data as it emerges, as the market to some degree can predict the future policy decisions from the Fed which will in turn affect markets.

The Effect of Quantitative Tightening on Inflation

  • What is quantitative tightening and how does it affect inflation?
  • How long does it take for the effects of quantitative tightening to trickle down and affect metrics like CPI and PCE?

Quantitative Tightening (QT) refers to the process by which central banks shrink the money supply by selling assets onto the market and buying back bonds from the public. This in effect destroys the circulating currency and suppresses demand for assets by overflowing supply. The US Fed has been engaging in QT since the middle of last year.

The last 3 Core PCE data releases show inflation is clearly cooling off, and this should not be surprising when you look at the money supply. Try not to get it confused by thinking it’s the interest rate that moves inflation because it’s not, at best interest rates will distort inflation by affecting the demand for currency. In truth, it is simply the money supply that is the true indicator of currency inflation, and this money supply has shrunk by nearly 1 Trillion in 9 months.

M2 Money Supply Table & Chart (Fred, US Federal Reserve, 2023)

What we are witnessing now is the base case of that shrinkage in the money supply and its effect on inflation. It takes about 9-12 months for this effect of quantitative tightening to trickle down and affect metrics like CPI and PCE, this is where we are at now. We can see PCE has been trending down on a month-to-month basis and this trend is likely to continue for the next few months.

PCE Data 2022-2023 (BEA, 2023)

The Importance of Trends in Inflation Analysis

  • Why is it better to look at the trends in inflation analysis rather than try to forecast to a specific accuracy?
  • What is the current trend in PCE and what does it suggest?

With this type of analysis, it is better to look at the trends rather than try to plan a trade around inflation data coming in at 4.4% instead of the predicted 4.5%. The truth is the greater majority of people who are trying to forecast with that type of accuracy are out of their depth and would be better off just watching where inflation is trending to inform their analysis. Additionally, if trading around the announcement, ensure your strategy can withstand high levels of volatility, or risk having your trade swept up by whipsawing price action.

Keeping that information in mind, with inflation heading down we are likely to see a positive market reaction once the dust settles following Friday if the data can keep consistent with its trend. This will signal for the Fed to perform a 25bps hike in May and then pause interest rate hikes for a period, creating a degree of certainty for the near future which markets will likely enjoy. Core PCE will be announced by the US Federal Reserve Friday 10:30 pm AEST.

Market Certainty Around the Next Interest Rate Hike in May’s FOMC Shows 80% Probability of a 25bps Hike (CME Fed Watch, 2023)

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