The best thing to happen to the S&P 500 in 2023 — with the possible exception of the artificial intelligence boom — was the dramatic comedown of inflation in the second half of the year, even as the economy gained steam. Yet there’s some risk that Friday’s consumer price index revisions could alter some of that good news and deal a potential setback to Federal Reserve rate-cut expectations.
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CPI Seasonal Adjustment Update
Bureau of Labor Statistics revisions due on Friday morning will affect only the seasonally adjusted CPI data, which means the 12-month inflation rate won’t change. The key question is whether the new data will confirm that inflation came down as rapidly as initially reported over the past six months, or whether disinflation was more evenly spread out over the full year.
When it comes to inflation, the recent trend matters almost as much as the 12-month inflation rate. The Fed’s primary inflation rate, the core PCE price index, ended 2023 at 2.9%. While that was a big drop from 4.9% in 2022, it is still nearly a full point above the Fed’s 2% target.
Inflation Trend Fuels Fed Rate-Cut Hopes
What really fueled expectations of near-term and significant Fed rate cuts was the plunge in core PCE inflation to a 1.9% annual rate over the second half of 2023, from 4% in the first half.
Could seasonal adjustment changes really alter the recent trend? That’s exactly what happened last February. “Last year’s update of CPI seasonal adjustment factors was a big deal, showing inflation momentum was stronger than thought at the end of 2022, catching both the market and the Federal Reserve off guard,” wrote ING chief international economist James Knightley.
Friday’s update “could be a bit of a nonevent,” Knightley wrote. “That is our base case, but we have to remain open to the potential for a surprise that could meaningfully alter the market’s view on the timing of Fed policy changes.”
Last year’s seasonal adjustment shift lifted the 3-month annualized rate for core CPI inflation to 4.3% from 3.1% in the fourth quarter of 2022.
Fed Gov. Waller: CPI Update Is Key
In a recent speech, Fed Gov. Christopher Waller made clear that a lot is riding on the updated seasonal adjustments for inflation. “My hope is that the revisions confirm the progress we have seen, but good policy is based on data and not hope.”
The CPI and PCE price index are constructed much differently. Housing costs account for over one-third of the CPI’s weighting, but just 15% of PCE spending. Health care makes up 16% of PCE spending vs. just 6% of the CPI. That’s because the CPI only reflects direct purchases by the consumer, not indirect spending, such as employer payments for employee health care.
Partly because of those differences, core CPI inflation has run at 3.9% over the past year, a full percentage point higher than core PCE inflation. Over the past six months, the core CPI has run at a 3.2% annualized rate, down from 4.6% in the first half of the year.
Still, most of the changes that affect seasonally adjusted CPI data will feed through to the PCE price index. Other PCE data comes from the producer price index, whose seasonal adjustment factors will be updated on Feb. 14.
Federal Reserve Rate-Cut Odds
As of Thursday morning, after the Labor Department reported that new jobless claims fell a bit more than expected to 218,000 in the week through Feb. 3, markets were pricing in just 16.5% odds of the first rate cut coming at the March 20 Fed meeting. Markets see 60% odds of a rate cut by May 1, according to CME Group’s FedWatch tool.
Markets see a year-end federal funds rate of 4.2%. That implies 58% odds of five quarter-point rate cuts, and 42% odds of four cuts.
S&P 500
The S&P 500 dipped a fraction in early Thursday stock market action, as Treasury yields pushed higher. On Wednesday, the S&P 500 climbed 0.8% to a record closing high, as technology stocks fueled the rally.
Be sure to read IBD’s The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.
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Image and article originally from www.investors.com. Read the original article here.