Gold surged on US shutdown drama and softer core PCE inflation

·         Wall Street also recovered from the Fed panic low on renewed hopes of another Fed rate cut in March, but Nov’24 core PCE inflation is in line with the Fed estimate

·         Fed may cut in June and Dec’25 instead of every alternate meeting not only for stalled core disinflation but also to assess Trump 2.0 bellicose policies, if implemented at face value

·         The yearly ritual of US Government shutdown drama is usually negative for USD and positive for UST, and Gold to some extent

·         But late Friday, the US shutdown soap opera ended as Capitol Hill passed a stopgap funding bill as expected

Wall Street, Gold slumped even after the expected 25 bps Fed rate cut as the Fed projected a 50 bps cumulative cut in 2025 instead of the earlier 100 bps. Fed has already cut an additional 50 bps in H2CY25 despite stalled core disinflation and thus may cut less in 2025, with a pause in January and March’25. As per the latest (Dec 24) dot plots, the Fed may cut in June and Dec’25 @25 bps each, totaling 100 bps. In brief, the Fed almost poured cold water on the yearly Santa Rally of Wall Street.

Wall Street Futures slid on less dovish or fewer than expected Fed rate cuts in 2025; Gold and Silver also stumbled.  Also year-ending US debt crisis ritual and US government shutdown drama affected Wall Street, while supporting Gold to some extent. On Thursday, hotter-than-expected US GDP data also dragged Gold and even Wall Street, despite soft landing optimism. Dow Future was in a downturn for the 9/10 consecutive trading sessions, not seen since 1974.

Fed put may now be in jeopardy under Trump 2.0 amid lingering uncertainty of Trump policies, especially immigration/deportations and also tariffs, which may affect both the US labor market and price stability. Fed is also cautious about stalled core disinflation for the last few months while underlying labor market and economic activities are robust.

On Friday (20th Dec’24), 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, but below the market expectations of +2.9% and highest in the last 7-months. The US core PCE inflation is still substantially above pre-COVID levels 1.5-1.7%, 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.

On a sequential (m/m) basis (seasonally adjusted) the U.S. core PCE inflation was increased by +0.1% in Dec’24 against +0.3% in the prior month, and lower than the market expectations of +0.2% and the lowest monthly gain in the last six months. The Fed needs the sequential average core PCE inflation running around +0.1% (0.2-0.0.0%) consistently for its price stability real target of annual core PCE inflation around +1.5%.

Although the sequential core PCE inflation rate was almost the same as that of core CPI inflation, overall, for 2024 (YTM), the average sequential rate of core PCE inflation was around +0.2% against core CPI and PPI +0.3%. 

Overall, after the latest revisions, considering sequential, YTM, and 3M/6M trends, the underlying average core PCE inflation was around +2.7% in Nov’24. The US core PCE inflation needs to go around 1.5% from present levels of YTM average +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 +2.4% against +2.3% sequentially, below the market expectations of +2.5%, but 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 +0.1% in Nov’24 against +0.2% in the prior month and lower than the market expectations of +0.2%.

Overall, after the latest revisions, considering sequential, YTM, and 3M/6M trends, the underlying average PCE inflation was around +2.3% in Nov’24. The US total PCE inflation needs to go around 1.5% from present levels of YTM average +2.5%; i.e. almost around 100 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 was edged up to +2.5% from 2.4% (y/y). The US super core PCE service inflation was around +1.3% in pre-COVID days on average (YTM-2019).

On Friday, Wall Street Futures and also Gold recovered from Fed panic low amid short covering and fresh buying after US core PCE data came softer than expected by the market (by 0.10%). But on Wednesday, Fed Chair Powell also projected November core PCE and total PCE inflation at +2.8% and +2.5% (y/y) respectively. The actual data shows USA core PCE inflation for Nov’24 at +2.8%, while total PCE inflation at +2.4%. The median market estimation was at +2.9% for core PCE and +2.5% for total PCE inflation.

In any way, stimulus/rate cut-addicted Wall Street has now again begun rate cut expectations (around 44%) in Mar’25 after a pause in Jan’25. Thus Wall Street and Gold got some boost on renewed hopes of another 25 bps rate cut in Mar’25. Over the last few years, after COVID, Wall Street was mainly controlled by the Fed through its jawboning and rate action. But now under Trump 2.0, we may expect Trump tweets/truths to influence the market like in Trump 1.0. In that sense, the market may not be Fed monotonous for the next few years and it may be also a challenge for the Fed to deal with Trump’s unpredictable/unconventional policy tantrums and fiscal math.

The Fed usually goes by a 3M/6M/12M rolling average of core inflation (PCE+CPI) for any important policy move. After the latest revisions, the 2014-YTM average US core inflation (CPI+PCE) is now around +3.1% (vs +3.1% in the previous report), still around 1.0% above the Fed’s +2.0% targets. The US average 2024-YTM unemployment rate is now at 4.0%

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).

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 +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%; now YTM average at 2.8%

·         Core CPI inflation target +2.3%; now YTM average at 3.5%

·         Unemployment targets 3.5%; now YTM average at 4.0%

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

As per Taylor’s modified rule, considering the desired real REPO rate of +1.0%, core CPI inflation targets of +2.3%, unemployment targets of 3.5%, and real GDP growth targets of 3.0% (expected 2024 average levels),  the Fed should cut REPO rate from present +4.50% to 4.0% by Dec’25.

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 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 -0.10% 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 re3strive 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.

Conclusions

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 now cutting 100 bps in H1CY24 to catch up. Fed may like to keep the repo rate at 4.5% against average core CPI inflation for 2024 around 3.5% for a real repo rate +1.0%, moderately restrictive, but lower than 2.0% in H1CY24, when the repo rate was 5.50% against average core CPI inflation +3.5%. Looking ahead, the Fed may like to keep the core real rate around +1.00% and cut gradually every six months till Dec’27 for a repo rate of +3.00% from +4.50% at present.

As US core inflation (CPI+PCE) almost stalled or even edged up in H2CY24 around +3.0% on average, while the unemployment rate remains stable at around 4.0% along with resilient Real GDP and PDPF growth around 2.9% on average, the Fed should have paused in December’24. However, the Fed may have missed the opportunity of two rate cuts in H1CY24 despite favorable core inflation data. Thus to catch up after the unemployment rate ticked up, the Fed cut a cumulative -100 bps cut in H2CY24 (by front-loading to stay ahead of the curve). Fed has to also synchronize with BOC, ECB, BOE, SNB, and various other European and APC central banks, most of which are in rate-cutting sprees like in a crisis to avert a looming stagflation or even an all-out recession.

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.

Thus the Fed cut on 18th December for a cumulative rate cut of 100 bps in 2024 to a repo rate of 4.50% against the average core CPI of 3.5% for 2024, so that the real repo rate remains around +1.00%. Fed may have made a policy mistake by not cutting from H1CY24 when 3MRA of core CPI was around +3.5% on average. Thus Fed is now cutting 50 bps extra in H2CY24 to stay ahead of the curve.

Bottom line:

Fed is scheduled to cut 25 bps next in March’25 after pausing in January and March for stalled core disinflation, solid labor market, resilient economic activities, and also to assess Trump 2.0 bellicose policies, whether it will be implemented at face value or not.

But despite a 50 bps projected rate cut in 2025-26, the Fed may also cut 75 or even 100 bps each if Trump’s immigration and tariff policies are less hawkish in reality due to moderate Musk & Co., who may ensure good relations between Trump/US with China and Russia (Putin); Musk has not only good business relation with China but also a good ‘personal/diplomatic’ relation with Putin for the last few years.

Fed front-loaded 50 bps rate cuts for 2025 in H2CY24 and thus may cut only 50 bps in 2025. But the Fed may also change its stance in the coming months and go for 100 bps rate cuts in 2025 if the US unemployment rate ticked up towards 4.5%, while core CPI inflation ticked down below +2.5%. We have to keep in mind Fed often changes its goalposts to suit its narrative/stance/rate action even after contradictory jawboning.

The Fed should maintain more credibility as the Fed is the de-facto central bank of the world and controls almost all types of financial asset classes, with USD being the undisputed preferred global trade & reserve currency. Fed is also doing QT along with rate cuts, which are almost opposite to each other, but the Fed is also defending it as a part & parcel of policy normalizations. 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. Lower borrowing costs/lower bond yield would be also positive for stocks and higher bond prices may also boost gold to some extent.

Market Impact:

Wall Street Futures slid Wednesday and Thursday on less dovish or fewer than expected Fed rate cuts in 2025; Gold and Silver also stumbled.  Also year-ending US debt crisis ritual affected Wall Street, while supporting Gold to some extent. On Thursday, hotter-than-expected US GDP data also dragged Gold and even Wall Street, despite soft landing optimism. Dow Future was in a downturn for the 9/10 consecutive trading sessions, not seen since 1974. Fed out may now be in jeopardy under Trump 2.0.

But Wall Street Futures, Gold also recovered Friday from Fed panic low on renewed hopes of another Fed rate cut in March’25 after softer than expected core PCE inflation data, although actually, iy\t was in line with the Fed expectations. And Fed will not take any policy action based on just one month of slightly softer core PCE inflation data as overall core disinflation may have stalled in H2CY24. The last mile of disinflation is always tough for unfavorable base effects.

Weekly-Technical trading levels: DJ-30, NQ-100, SPX-500, and Gold

Looking ahead, whatever the fundamental narrative, technically Dow Future (CMP: 45100) now has to sustain over 45500 for any further rally to 45800/46000-46200/46400 and 46800/47000-47500/48000 in the coming days; otherwise sustaining below 45450/45200, DJ-30 may again fall to 45000/44750-44650/44200, DJ-30 may again fall to 43900/43300-42600/41600 in the coming days.

Similarly, NQ-100 Future (21450) has to sustain over 21200 for a further boost to 21500 and further to 21700/21900-22050/22500 and even 21450 levels in the coming days; otherwise, sustaining below 21150, NQ-100 may again fall to 20950/20850-20500/20300 and 20000/19800-19650/19350 in the coming days.

Technically, SPX-500 (CMP: 6050), now has to sustain over 6100 for any further rally to 6150/6200-6350/6500 in the coming days; otherwise, sustaining below 6075/6050 may again fall to 6000/5950-5900/5850 and 5675/5600-5550/5500 in the coming days.

Also, technically Gold (CMP: 2650) has to sustain over 2680 for a recovery to 2700-2725 and further 2735/2750-2775/2795 and 2815 in the coming days; otherwise sustaining below 2655-2630 may again fall to 2605/2600 and 2590/2565 and further fall to 2550/2500-2470/2450 in the coming days (depending upon Fed rate cuts, Gaza/Ukraine war trajectory); Gold surged almost 75% in the last one year since Gaza war started back in October’23. Now it may retrace to $2100 levels if Trump indeed can mediate both Gaza and Ukraine war ceasefire by early 2025.