Fed’s Favorite Inflation Measure Helps Rates Today, What About Tomorrow?

The Consumer Price Index is probably the most widely watched consumer inflation gauge, but the Fed watches Personal Consumption Expenditures the closest and May PCE came in at +0.1% versus expectations of +0.2%. This is a “core” reading which excludes food and energy expenditures, and it brought the May-to-May inflation rate to 2.1%. Given the 2% Fed Funds Rate, this PCE inflation reading puts inflation adjusted rates at just below zero…that is, Fed Funds Rate of 2% minus core PCE year-over-year of 2.1% equals -0.1% real interest rates. If you include food and energy in the PCE reading, personal consumption expenditures rose 0.4% from April to May, and rose 3.1% from a year earlier. This means -1.1% real rates.

Much of the media reported on the lower-than-expected 2.1% core number being a welcome development for the Fed who defines 1-2% inflation as price stability. But not much on the 3.1% number that includes ever-increasing food and energy prices. The Fed’s statement earlier in the week following their FOMC meeting indicated that financial sector strain and a generally weak consumer might offset inflationary threats. But there’s two forces working against this: (1) most inflation readings seem to be “Core” readings which aren’t capturing the full inflationary threat, and (2) real rates are negative which means the Fed might have to hike rates sharply with little notice.

Rate markets reacted well to this “Fed comfort zone” inflation data, and rates dropped partly because of this and partly because of a new wave of credit crunch nervousness hitting banks. But tomorrow and beyond are likely to be a different story.