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

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) 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.

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