Inflation - Income Growth Misses Estimates & Inflation Meets Them

Personal income growth in the September PCE report came in at 0.2% on a month over month basis. It missed the consensus for 0.4%.

Stripping out taxes, real disposable income growth was 0.1%.

As you can see from the chart below, year over year real disposable income growth was 2.9%. It supported real consumer spending growth of 3%.

Since spending growth was faster than income growth, the savings rate fell to 6.2% which is the lowest rate since December 2017. On a month over month basis, consumer spending growth was 0.4% which met estimates.

Spending on durables was up 1.4% month over month. It may have been helped by the vehicle replacement demand caused by hurricane Florence.

Next month will have the same spike because of hurricane Michael. Spending on non-durables was only up 0.3%.

Inflation Matches Estimates & The Fed’s Target

The headline PCE price index was up 0.1% month over month which matched estimates. It was up 2% year over year. That met estimates and was down from 2.2% last month.

Headline inflation will likely fall further in October. Oil prices have plummeted along with the overall market.

Technically, the Fed says it follows headline PCE inflation. However, in action, the Fed always seems more concerned with core PCE.

We’re in an unusual situation where core and headline inflation were the same at 2%. This is also the Fed’s goal. It’s the rare perfect inflation report for the Fed.

As you can see from the chart below, core PCE has been steadier than core CPI. On a month over month basis, core PCE was up 0.2%. That beat estimates for 0.1%.

Even though inflation matched expectations, the expectations for rate hikes in 2019 have fallen. This is because of the ‘risk off’ trade.

All stock market declines don’t affect the Fed funds futures market. But once stocks fall over 5%, it’s fair to expect the market to price in fewer rate hikes.

As you can see from the chart below, the eurodollar futures went from expecting a 60 basis point increase in the Fed funds rate in 2019 to a 40 basis point increase.

That’s almost one hike that was taken off the table. This was due to the 10% correction in the S&P 500. It's far in advance, which means if the stock market recovers, there could be 2 hikes next year.

Let’s quickly look at the base effects from the core PCE inflation report to see where the reading might be headed.

Inflation was relatively strong compared to last month

Core PCE was up 1.41% in August 2017 and 1.48% in September 2017. It was up 1.96% in August 2017 and 1.97% in September. This means the 2-year stack increased 8 basis points.

The July 2 year stack was 3.53% which is 8 basis points higher than September. In October 2017, core PCE was up 1.58% which means next month should be the beginning of the end of 2% core PCE.

I’ve heard analysts claim the Fed isn’t data dependent. It’s dependent on its forecasts. That’s a fair point because the Fed hasn’t followed inflation. It raised rates 3 times in 2017 when inflation fell.

This prognostication implies the Fed thinks inflation will roar higher next year. And, it is about to raise rates 4 times in 2018.

The best assertion for rising inflation is tariffs and wage growth will start driving prices higher.

Tariffs are starting to affect consumer goods. Meaning, CPI and PCE could be headed higher soon. I think the Fed is dependent on its forecasts as well as the stock market and the Fed funds futures market.

Inflation - Solid Dallas Fed Report

The October Dallas manufacturing report was strong. The production index fell from 23.3 to 17.6 and the general activity index increased from 28.1 to 29.4.

The consensus was for 28 and the highest estimate was 29. Both were beaten. With this report in, we can get a better picture of the overall manufacturing economy. That helps us forecast the manufacturing ISM PMI which will come out on Thursday.

As you can see from the chart below, the regional fed reports expect the PMI to fall to 56. The consensus is for it to fall from 59.8 to 59.

New orders index was up 4.2 points to 18.9. Inflation was strong as the prices paid index was up 10 points to 54.4. Prices received index was up 3.9 points to 17.5. Capex reading was up 7.5 points to 24.5.

As you can see from the chart below the average capex plans in the regional Fed reports declined. The Dallas Fed reading helped it decline less. Company outlook was up 6.8 points to 25. Outlook uncertainty was down 13 points to 6.9. Six-month expectations for production was up 4.2 points to 47.9.

The best quote was from a primary metal manufacturing firm which stated, “tariffs need to be resolved”.

That simple statement sums it up best as costs will be increasing.

A non-metallic mineral product manufacturing firm stated, “China tariffs at 25 percent could be a problem. Many manufacturers are increasing their selling prices to home builders. This will cause further increases in the selling pricing of new homes”.

Finally, a machinery manufacturing firm stated, “Tariffs distort the free market. Interest rates are prices which should be controlled by the market, not the Federal Reserve. Central planning is never good. Allow the free market to make America great”.

Inflation - Conclusion

The PCE report feeds into the strong personal consumption expenditures growth in the Q3 GDP report.

Our economy seems to be slowing. But growth is still strong in many areas. And, inflation is exactly what the Fed wants.

Some analysts claim the stock market is predicting a recession in 2019. That’s incorrect.

The stock market is testing for a recession by declining. But the subsequent performance in the next few weeks tells us if the market sees a recession coming soon. The data certainly doesn’t show one is coming in the next 12 months.