Some Relief on Fed’s Favorite Inflation Measure; Powell Says The Clock is Ticking on Preventing Sustained High Inflation

FS Insight Team

The Fed’s favorite inflation gauge came in this week. The PCE rose 0.2% in May but fell 0.5% when inflation was considered. Personal incomes were a similar story as well. They rose .5% but after being adjusted for inflation the number was down 0.1% while prices continued rising in May at a clip of 0.6%. This was cut in half when food and fuel prices were excluded. Encouragingly, the indicator without food and fuel included declined for the third consecutive month.  There has been a deceleration in the prices of many key goods and services, but elevated energy prices are continuing to squeeze the consumer. Energy prices can have a particularly vicious inflationary impact since they also affect transportation costs.

The inflationary pressures along with a decelerating economy appear to be squeezing net profit margins. Estimates for margins in the Consumer Discretionary sector have come down from 6.7% to 6.4%. Other assets have taken a pummeling this quarter. While stocks had their worst first half since 1970, investment grade bonds had their worst start to the year ever. The TINA justification for stocks is also diminishing. Micron (MU 4.78% ) made an announcement that their EPS expectations for the approaching quarter had gone from around 10% above consensus to 37% below consensus. The S&P 500 earnings yield is only at 5.3% right now, which is at the narrowest spread with the US investment grade bond yield in twelve years. Investment grade bonds are at about 4.7%. There has also been weakness in high-yield bonds which are at 8.6%, their highest level since 2016. One encouraging development was that long-term inflation expectations came down. However, one should also consider that in the last comparable period of inflation (The Great Inflation) short-term inflation expectations carried more importance than they do in normal times. As Karen Dynan, a Harvard Economic Professor said, “If you look back to the 1970s and ‘80s when inflation was high and exciting and noticeable,” short-run expectations actually mattered more.

Jay Powell went to the European Central Bank Forum in Sinatra, Portugal this week where he was joined by his European counterparts. The BOE, ECB and Fed are all tightening simultaneously for the first time in over a decade. On Wednesday, Jay Powell spoke at the event and did not seem very concerned about causing a recession. Essentially, he said that preventing inflation from becoming unanchored was the Fed’s biggest proverbial fish to fry. Powell put it in very clear terms. “Is there a risk we would go too far? Certainly, there’s a risk,” the Chairman admitted but then he continued to say that “The bigger mistake to make—let’s put it that way—would be to fail to restore price stability.” This seems somewhat supportive of those saying you shouldn’t expect the cavalry to come charging in and restore accommodative central bank policy anytime soon, even in the face of recessionary consequences.

Powell is hard-pressed toward ensuring we don’t enter a sustained period of inflation. The Chairman has stressed and admitted that the Federal Reserve’s policy can do little about supply interruptions from a ground war in Europe, but these interruptions nonetheless make his job significantly harder. He acknowledges that the pathways toward a soft landing have gotten considerably narrower. Somewhat ominously, he also said that “the clock is kind of running out on how long will you remain in a low-inflation regime.” If some folks thought the Fed was facing a Sophie’s Choice between curtailing inflation and curtailing growth (and the collateral damage that occurs as a result), the Fed is clearly saying that they would prefer to tame inflation.

The 10-yr came down significantly this week. They started the week at 3.2% and settled below 2.9% on Friday. The rates are likely coming down as recession fears start to rise. They came down after the PCE reading and after Powell’s remarks on Wednesday. Fed Governor Loretta Mester also mentioned she sees the Fed as on course for another 75 bps hike at the upcoming meeting. The Atlanta Fed’s GDP tracker showed an estimated growth rate of -2.1% for the second quarter, suggesting the United States economy may already be in the midst of a recession.

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