A Data Dependent Fed Should Stick to the Script

Please note, there will not be any commentary published for the week of 12/30 through 1/3.

A Data Dependent Fed Should Stick to the Script

•     PCE grew 0.1% month over month in November.

•     The six-month average pace of growth sits at 1.9%.

•     The data point to inflation pressures continuing to ease.

Inflation growth continues to slow…

Last week, the Federal Reserve threw investors everywhere for a loop. As part of its fourth-quarter summary of economic projections, policymakers raised the outlook for inflation growth next year from 2.1% to 2.5%. Wall Street worried the shift could hurt the outlook for rate cuts next year and sent stocks tumbling over 3% late last Wednesday.

When asked what drove the change, Chairman Jerome Powell had a surprising response. He said some central bank officials adjusted for policy proposals put forward by President-elect Donald Trump. Powell suggested those Fed members are worried about the potential boost to prices that could be driven by the introduction of tariffs and a shrinking labor pool due to a lack of immigration. That came as a curveball considering Powell had repeatedly said policymakers won’t react to changes that had yet to happen.

But the drama overshadowed an important event that took place at the end of the week. On Friday, we received the latest update on price pressures from the U.S. Bureau of Economic Analysis (“BEA”). And our central bank’s preferred inflation gauge, personal consumption expenditures (“PCE”), showed the pace of price growth continues to ease.

That’s a big deal as it relates to the inflation and growth outlooks for next year. You see, In fact, based on some measures, price pressures are sustainably holding below the Fed’s 2% target. That means the central bank’s new guidance for just two rate cuts in 2025 could prove to be too conservative. The change will support a steady rally in the S&P 500 Index.

But don’t take my word for it, let’s look at what the data’s telling us…

Friday’s release showed PCE growth increased 2.4% on an annualized basis in November compared to the 2.2% result in October. Now, while it may seem concerning at first glance that the number increased compared to where it was a month ago. We need to dig into the details to have a better understanding of what’s going on. And when we look below the surface, we see that the more forward looking six-month average is holding below the Fed’s 2% target.

To get there, we must look at the monthly result. According to the BEA, inflation rose 0.1% in November. That compared to the consensus expectation for a 0.2% increase and October’s 0.2% gain. But, as you’ll notice in this next chart, after erratic swings over the past few years, the monthly numbers are starting to stabilize in a tighter range…

Now, let’s look at the average pace of PCE growth over the last six months. We can see this by observing a table of the month-over month results…

As you can see in the rows to the right, after starting off the year hot, the rate of monthly PCE growth is easing. The average monthly increase from June through August is 0.16% (1.9% annualized). That compares to the 0.25% (3% annualized) typical gain from December 2023 through May of this year.

The current pace of monthly PCE growth is back in-line with the pre-pandemic average. In fact, November marked the fourth straight month the six-month average pace of headline PCE growth has been at the Fed’s 2% target or lower…

So, based on the current monthly average, headline PCE growth could drop below our central bank’s annualized 2% target sooner than you think. Based on my math, that change could happen as soon as February of next year. And, if we continue to maintain a steadier, pre-pandemic level of price growth, PCE has the potential to still be at or below 2% for the rest of 2025.

That would be a big deal as it affects the outlook for rate cuts next year. Between 2000 and 2020, our central bank kept a real rate of interest (effective fed funds rate minus PCE) of -0.05%. Right now, the real rate of interest sits at 2.2%. In other words, it has a lot of room to cut rates before it hits neutral (neither hurts nor helps the economy).

Look, I can guess what might happen to prices if the incoming administration enters into a trade fight… costs will rise. But if that happens, I’m more worried about the economic demand outlook than I am about inflation. You see, Americans are tired of high prices. Just look at the numbers from discount retailers like Walmart and Costco. Demand is off the charts because they offer cheaper alternatives.

So, instead of guessing what may or may not happen, I want to focus on what I can control. And based on what I’m seeing, policymakers have a ton of room to help support the economy. And if they don’t need to take action, even better. But to me, the scenario should support stable growth and underpin a steady rally in the S&P 500.

Five Stories Moving the Market:

The Federal Reserve is weighing “significant changes” to its annual stress tests for large U.S. banks that would reduce volatility of tests’ results and make the process more transparent; the central bank did not provide a detailed account of the changes but said they could amend models that calculate hypothetical losses for banks, averaging results over two years to lessen the risk of large year-on-year swings – FT. (Why you should care – increased transparency for the stress tests would boost investor confidence in the financial system)

Australia’s central bank is more confident that inflation is moving sustainably toward target but it’s still too soon to conclude the battle is won given a recent pick-up in consumption and a still-tight labor market, minutes of the December meeting showed – Bloomberg. (Why you should care – the Reserve Bank of Australia is moving closer to lowering interest rates once more)

Bank of Japan policymakers agreed in October to keep raising interest rates if the economy moves in line with their forecast, but some stressed the need for caution due to the uncertain outlook, minutes of the meeting showed – Reuters. (Why you should care – BOJ policymakers sound increasingly cautious about the economy’s ability to handle additional rate hikes)

Confidence among American consumers dropped unexpectedly this month, with expectations growing bleaker for the economic situation in the new year; an index of sentiment published by research group the Conference Board dropped 8.1 points to 104.7, defying hopes for an increase, according to a consensus of economists – WSJ. (Why you should care – souring consumer confidence is likely to weigh on economic demand and inflation growth)

Canada’s economy may have contracted last month for the first time this year, but growth has nevertheless picked up this quarter, supporting the central bank’s pivot to a more gradual pace of rate cuts in 2025; preliminary data suggest industry-level gross domestic product dipped 0.1% in November, Statistics Canada said – WSJ. (Why you should care – slowing growth in Canada will likely spill over into the U.S., also placing downward pressure on output)

Economic Calendar:

U.S. Equity Markets Close at 1 p.m.

Bond Markets Close at 2 p.m.

European Markets Close Early

BOJ Meeting Minutes

RBA Meeting Minutes

U.S. – Building Permits for November (8:30 a.m.)

U.S. – Durable Goods Orders for November (8:30 a.m.)

U.S. – New Home Sales for November (10 a.m.)

U.S. – Richmond Fed Manufacturing Index for December (10 a.m.)

Treasury Auctions $70 Billion in 5-Year Notes (11:30 a.m.)

Treasury Auctions $28 Billion in 2-Year Floating Rate Notes (11:30 a.m.)

U.S. - American Petroleum Institute Crude Oil Inventory Data (4:30 p.m.)