Fed may not cut before June’25 amid stalled core disinflation

·       After December’24 core PCE inflation data, 3MRA of US core inflation (CPI+PCE) was around 3.1% against Fed targets of 2.00%

·       At a present run rate of around 0.05% disinflation per month on average, it may take almost 2027 to achieve the Fed’s price stability target

·       The Fed may also keep a less dovish approach as Trump’s bellicose tariffs and immigration policies along with planned fiscal stimulus and deregulation may boost inflation

On Friday (31st Jan’25), apart from the ongoing Trump trade war, some focus of the market was also on U.S. Core PCE inflation, the Fed’s preferred gauze to measure underlying inflation trends. The BEA flash data showed U.S. annual (y/y) core PCE inflation (Seasonally Adjusted-SA) increased by +2.8% in Dec’24, unchanged from +2.8% sequentially, in line with the market expectations of +2.8% and highest since Apr’24. The US core PCE inflation was stalled at around +2.8% in Q4CY24 and +2.7% in Q3CY24.

The US core PCE inflation is still substantially above pre-COVID (Dec’19) levels of 1.5%, which is also an ideal/actual target of the Fed as core PCE inflation always comes around 0.5-1.0% lower than core CPI inflation due to different methodologies. The Fed targets core PCE inflation at around +1.5% and core CPI inflation at +2.3% on a sustainable basis, the average of which is +1.9% and just below +2.0% targets.

On a sequential (m/m) basis (seasonally adjusted) the U.S. core PCE inflation was increased by +0.2% in Dec’24 against +0.1% in the prior month and line with the market expectations of +0.2%. The 2024 average core PCE inflation was around +0.2% against core CPI +0.3% and core PPI +0.3%. Overall, after the latest revisions, the 2024 average core PCE inflation was around +2.8%, while the 3MRA is also around +2.8%. The US core PCE inflation needs to go around 1.5% from present levels of +2.8%; i.e. almost around 130 bps for the Fed’s price stability target.

On Friday, the BEA flash data showed U.S. annual (y/y) total PCE inflation (Seasonally Adjusted-SA) increased by +2.6% against +2.4% sequentially, in line with the market expectations of +2.6%, the highest in seven months and still above +1.5% pre-COVID (Dec’19) average levels or actual targets of Fed, equivalent to total CPI around +2.3%. On a sequential (m/m) basis (seasonally adjusted) the U.S. total PCE inflation was increased by +0.3% in Dec’24 against +0.1% in the prior month and line with the market expectations of +0.3%.

Overall, after the latest revisions, the 2024 average PCE inflation was around +2.5%, while the 3MRA is around +2.4%. The US PCE inflation needs to go around 1.5% from present levels of +2.4%; i.e. almost around 90 bps for the Fed’s price stability target.

In Dec’24, the so-called U.S. super core PCE inflation (w/o food, energy, and housing), the current focus of the Fed, edged down to +2.4% from 2.5% (y/y). The US super core PCE inflation was around +1.4% in pre-COVID days (Dec’19).

The Fed usually goes by a 3M rolling average of core inflation (PCE+CPI) for any important policy move.  The 3MRA of average core inflation is now around 3.1%, while the unemployment rate is 4.1% against the target of 2.0% and 3.5%. Usually, the Fed considers 4.0% average levels (orange line) as minimum unemployment; i.e. maximum employment (96% of the available work/labor force), sustainable in the longer run. But the Fed also considers a 3.5% unemployment rate as the lowest (green line), below which there may be a risk of deflation, while a 4.5% unemployment rate may be a red line for the Fed, above which there would be a risk of an all-out economic slowdown (hard landing) or even a recession (if sustained over a few months).

As the Fed now needs to bring down core inflation by around 110 bps to 2.0% and the unemployment rate by 60 bps to 3.5%, it’s maintaining that both sides of the dual mandate are in balance. In 2025, the Fed will try to bring down core inflation by around 2.0% from present levels of 3.1% by keeping the unemployment rate at least around 4.0%; thus Fed may cut only 50 bps in 2025 against 100 bps in 2024.

In brief, for the achievement of dual mandate (price stability and maximum employment), the Fed now needs to bring down average core inflation (PCE+CPI) to around +2.0% from the present levels of +3.1% without allowing the average unemployment rate materially above 4.0%. If the unemployment rate surges above 4.5%, then the Fed may go for a more rapid dialing back of the restrictive rate (deeper rate cuts), while 3.5% unemployment levels would be consistent with +2.0% core inflation price stability targets and 3.00-2.75% longer-term Fed terminal/neutral rate.

Although the Fed targets +2.0% core PCE inflation officially as a price stability target, in reality, usually it’s +1.5% on average due to a 0.5% lower spread with core CPI inflation. Fed's price stability TGT is just below 2.0% inflation on a durable basis; the Fed generally targets average core inflation (PCE+CPI) +1.9%-as core PCE inflation is generally -0.5% lower than core CPI. In reality, the Fed targets 1.5% core PCE and 2.3% core CPI for average core inflation at around +1.9%, but may never publicly acknowledge it to suit its narrative and change of goal posts as per evolving economic situations or financial conditions.

Thus Fed's average targets for the dual mandate: are 2025-27

·       Core PCE inflation target +1.5%; vs 2024 average at 2.8%

·       Core CPI inflation target +2.3%; vs 2024 average at 3.4%

·       Unemployment targets 3.5%; vs 2024 average of 4.0%

·       Fed's longer-term terminal/neutral repo rate: +3.0% or +2.75% (post-COVID) vs +2.50% (pre-COVID); now  REPO rate at 4.50%

Post-COVID, the Fed may maintain a real positive rate between 1.00-2.00% as per underlying economic conditions; for 2025, as core disinflation almost stalled in H2CY24, the Fed may prefer to maintain an average real interest rate around +1.50% against +1.00% in 2023 (wrt to average core CPI inflation). As per Taylor’s modified rule, considering the desired real REPO rate of +1.50% in 2025, the average core CPI inflation for 2024 is around 3.40% vs target of 2.30%; the average unemployment rate is 4.0% vs longer-term target of 3.50%; average real GDP growth +2.80% vs potential/target 3.00% (considering increasing population/immigrants w/o Trump policy), Fed REPO rate should be around 4.00% by Dec’25 against 4.50% in Dec’24; i.e. Fed should cut by cumulative 50 bps in 2025.

Although the Fed targets core PCE and core CPI inflation, in the longer run, it ensures both core and total PCE and CPI inflation are around 1.5% and 2.3% respectively, averaging a 2% inflation mandate by the US Congress. Fed, as well as the White House, needs to ensure 2% price stability on a sustainable basis in the medium to longer run as the general US public is now extremely unhappy about elevated price levels, almost 25% higher than pre-COVID days; people are more concerned about the higher cost of living or higher prices of even day-to-day goods & services rather than the rate of increase (inflation).

The US government of the day also needs to ensure proper policies in place for a smooth global supply chain even from China, without which the US can’t afford. Also the US, at present needs to develop a huge industrial ecosystem to compete with mighty China, the world’s number one factory house, which may not be possible at all now, but the US needs to increase the supply capacity of the economy, including housing and also other social and traditional/transport infra to match with increasing demand amid increasing immigrants/population.

The US is a country of global immigration, which also helps it into a major innovator and service-oriented economy. Also, semi-skilled/unskilled immigrants from South America, South Africa, South Asia, and other countries are essential for low-skilled jobs like hotels & restaurants, farming, agriculture, etc. If Trump indeed doubles down on his immigration policies and causes huge deportations of around 10/11M so-called illegal immigrants in the country, it may cause a severe labor shortage, resulting in a tighter labor market and higher wage/normal inflation.

In the US, Core CPI (Consumer Price Index) and Core PCE (Personal Consumption Expenditures) are two different measures of inflation used to gauge price changes in the economy as well as any change in consumer consumption behavior after any meaningful change of prices (excluding food and energy prices due to their volatility).

The key differences between US Core CPI and Core PCE inflation are:

·       Core CPI measures the change in the prices of a fixed basket of goods and services purchased by households (out of pocket), while Core PCE measures the change in prices of variable goods and services consumed by individuals (both excluding food and energy).

·       Core CPI focuses on the price changes of a fixed basket of goods and services typically consumed by urban households, while Core PCE has a broader scope, including all goods and services consumed by households, and adjusts for changes in consumer behavior in line with any significant price changes (e.g., substitution effects).

·       The Core PCE, on the other hand, includes a broader range of expenditures. It accounts not only for out-of-pocket expenses but also for various goods and services paid for by third parties, such as employer-provided health insurance. This means that the PCE captures a wider array of consumer spending and includes expenditures by non-profit institutions as well.

·       The CPI uses a specific formula, which is based on a fixed basket of goods. This means it does not adjust for changes in consumer behavior in response to price changes. For example, if the price of beef rises, the CPI does not account for consumers switching to chicken.

·       The PCE employs a Fisher ideal index formula, which allows for substitutions between items as their relative prices change. This flexibility typically results in a smoother inflation rate, as it reflects changing consumer preferences more accurately. For example, if the price of beef rises, the CPI does not account for consumers switching to chicken, but the PCE does

·       The weights assigned to different categories in the CPI are based on a fixed survey of consumer spending patterns. These weights are updated less frequently, which can lead to discrepancies over time as consumer behavior shifts.

·       The PCE updates its weights more regularly based on current expenditure data, reflecting more recent consumer spending habits. This results in a more dynamic representation of inflation as it adapts to changes in consumption patterns.

·       Historically, the Core CPI tends to report higher inflation rates compared to the Core PCE. For instance, since 2000, the average annual PCE inflation has been about 0.5% points lower than that of the CPI. This difference can be attributed to the broader scope and more adaptive nature of the PCE, which captures the effects of consumer substitution more effectively.

·       Both the Core CPI and Core PCE are essential for understanding underlying inflation trends in the U.S. economy.

·       The Fed prefers Core PCE because it provides a more comprehensive view of inflation and better captures changes in consumer behavior.

·       As price stability, the Fed eventually tries to converge both core and total inflation to the same levels; i.e. both core CPI and total CPI around +2.3%,  and core PCE and total PCE inflation +1.5% for a longer run.

Although the Fed generally targets +2.0% core PCE inflation as the price stability (inflation) target, in reality, it maintains that around +1.5%, which is equivalent to core CPI inflation targets around 2.3%. Before COVID, the Fed started cutting rates in late 2019 amid repo market disruptions (due to excessive QT) from Aug’19 (after Trump blasted out Powell), when 6MRA of core PCE inflation was around +1.6% and core CPI inflation was around +2.0%. Fed had cut rates from +2.50% to +1.75% in H2CY19 (pre-COVID).

The average rate of core disinflation was around -0.16% per month in 2023, which is now reduced to -0.06% per month in 2024. In 2023, the rapid pace of disinflation was due to the easing of the supply chain/constraints and also the supply of more workers/labor force amid huge immigration (legal/illegal). But the main effect of those easing in the supply chain (goods & labor/service) may be already over by 2023 (after withdrawal of all types of COVID restriction by late 2022) and thus we are now seeing comparatively slow, but predictable disinflation, although often stalled.

Goods inflation is also again ticking up in the US amid higher demand from increasing population/immigration; also demand for housing, especially rented homes is high and also resulting in elevated rent/housing inflation along with increasing geopolitical and global trade/supply chain fragmentation. At present trend, the US core CPI inflation may come down to around 2.3-2.0% on a sustainable basis by mid-2027. Thus Fed is now cautious about stalled core disinflation and wants to reduce the restrictive rate in an orderly manner or cautiously with a 50 bps cumulative cut each in 2025-27 rather than 100 bps in 2025-26. Fed already cut 100 bps in advance (front loading) in H2CY24 to ensure no hard landing after some unusual uptick in headline unemployment rate mid-2024.

Conclusions:

Although the Fed generally talks about 2.0% PCE inflation as a price stability target, in reality, it maintains 1.5% core/total PCE inflation and 2.3% core/total CPI inflation; i.e. around 1.9% average inflation (PCE+CPI) targets, Congress has entrusted along with maximum employment 96.0-95.5% of the labor force; i.e. 4.0-3.5% headline unemployment rate. Fed will now try to bring down average core inflation from around 3.0% to 2.5% by keeping the unemployment rate at least around 4.0% by December’25 and then 2.0% core inflation and 3.5% unemployment rate by December’26 to achieve its mandate of maximum employment and price stability.

As US core inflation almost stalled in Q4CY24 at around +3.1% on average, while the unemployment rate remains stable at around 4.1% along with resilient Real GDP and PDPF growths around 2.8-3.0% on average, the Fed should have paused in December to asses more data and Trump policies on inflation and employment. But the Fed cut 25 bps in Dec’24 too (after September and November) to make up for previous policy mistakes and be able to be ahead of the curve despite core disinflation almost stalled in H2CY24, while the unemployment rate remains stable around 4.0% and economic activity remains resilient.

Despite unfavorable data, and Trump policy uncertainty Fed cut on 18th December’24 to catch up with synchronized global easing and also to keep differential with ECB, which cut -100 bps in 2024. Fed may have also made a policy mistake by not cutting rates by 50 bps in H1CY24 and thus cut an additional 50 bps in H2CY24 to catch up.  

In H1CY25, the Fed may also share some concrete plans to end the QT, which may be positive for UST and negative for US bond yields, USD. Fed is now cutting rates while doing QT, which is two contra monetary policy tools. As a result, bond yields remain elevated at around 4.50% and the real economy may not be getting the full effect of a 100 bps rate cut in 2024. The market usually discounts Fed rate cuts well in advance in line with regular Fed talks and official dot plots.

Thus Fed may close the QT first by June’25 at B/S size around $6.60-6.50T from present levels of around $6.89T. Fed may keep the B/S size around 22% of projected nominal GDP around $30T by 2025, which may be an ideal level for the Goldilocks nature of the US economy and may not cause another REPO/Funding market crisis as we have seen late 2019 under Trump and Powell-1.0.

Fed may first close QT by June’25 and then resume the rate cut cycle for 50 bps cumulative in 2025. Fed may provide a definitive plan to end the QT in its March’25 meeting and close the same by June’25 and cut rates by 25 bps each in June and Dec’25.

Weekly-Technical trading levels: DJ-30, NQ-100, and Gold

Looking ahead, whatever the fundamental narrative, technically Dow Future (CMP: 44650) now has to sustain over 45300-45500 any further rally; otherwise sustaining below 45200, DJ-30 may again fall to 44500/44100-43700/43300 and 42800/41900 and further 41200/40600-40400/40000 in the coming days.

Similarly, NQ-100 Future (21900) has to sustain over 22200-22300 for a further rally to 22500/22700-23000/23300 in the coming days; otherwise, sustaining below 22100, NQ-100 may again fall to 21700/21300-21100/20700 and further 20500/20300-20100/19250 in the coming days.

Also, technically Gold (CMP: 2798) has to sustain over 2850 for a further rally; otherwise sustaining below 2840-2825 may again fall to 2770/2755-2725/2690 and further 2675/2655-2610/2560 in the coming days.