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Eyes on the Target (HINT: The Target is NOT CPI)

Updated: Sep 21, 2023

Much ink has been spilled on the topic of inflation over the past 12-18 months and in a sense, there’s not much to add to the ongoing conversation. However, our team does want to address the concept of the Fed’s oft-quoted, but sometimes misunderstood “2% inflation target” that gets bandied about in financial media and publications.

First, to take the words right from the horse’s mouth, in targeting a certain inflation level, the Fed does NOT manage primarily to the Consumer Price Index (PCI), but rather to the Personal Consumption Expenditures (PCE) Index:

The Federal Open Market Committee (FOMC) judges that an annual increase in inflation of 2 percent in the price index for personal consumption expenditures (PCE), produced by the Department of Commerce, is most consistent over the longer run with the Federal Reserve’s mandate for maximum employment and price stability. The FOMC uses the PCE price index largely because it covers a wide range of household spending.

That said, the Fed doesn’t ignore the CPI altogether:

However, the Fed closely tracks other inflation measures as well, including the consumer price indexes and producer price indexes issued by the Department of Labor.

Second, the Fed is also very concerned about not just headline PCE, but also the core components of inflation, as measured by the Core PCE Index (which excludes food and energy inflation):

Policymakers examine a variety of "core" inflation measures to help identify inflation trends. The most common type of core inflation measures excludes items that tend to go up and down in price dramatically or often, like food and energy items… Although food and energy make up an important part of the budget for most households--and policymakers ultimately seek to stabilize overall consumer prices--core inflation measures that leave out items with volatile prices can be useful in assessing inflation trends.

One anecdotal piece of evidence comes from Chairman Powell’s August 25th Jackson Hole speech, where he spends one paragraph discussing headline PCE (see paragraph four in the hyperlink above) and the following seven paragraphs (paragraphs five through eleven) discussing core PCE and its components. Interestingly enough, he does not mention CPI once in the prepared remarks.

What is the point of this exercise? As you’ve often heard us say, in both prior write-ups and other venues, “Don’t fight the Fed!” This means that when the Fed says they are committing to a 2% inflation target, they are committing to a 2% PCE target—and likely also want to see a 2% Core PCE trend as well—not a 2% CPI target. What’s more, the Fed has repeatedly said they follow inflation “trends” not data points. The Federal Reserve chair and governors surely know their history and know that inflation data points can often be head-fakes in one direction or the other (as happened frequently in the 1970s and 1980s) and want to avoid taking their foot off the proverbial gas pedal too soon.

So, what does it mean to “not fight the Fed” on inflation? First, it means we as investors must watch primarily what the Fed watches—namely the PCE and Core PCE indices. Does this mean CPI is useless? Of course not! What it does mean is that we are more concerned about PCE and Core PCE inflation trends than CPI data points as we seek to “Fed watch”. If CPI starts printing at 2%, but PCE and Core PCE remain in the 3-4% context, we expect the Fed to remain in a tight monetary policy position.

Second, it means acknowledging that interest rates will likely remain higher for longer. As the two charts below demonstrate, it will take consistent month-over-month (MoM) prints of +0.0%, +0.1%, or outright price declines for the Fed to quickly reach its 2% target. If the Fed is to be believed that 2% is its true target, then even +0.2% monthly won’t do it, since this is 2.4% annualized (source: Bureau of Economic Analysis, and kudos to the Bespoke Investment Group for the idea on the charts, even though they used CPI instead of PCE and Core PCE):

What does this all mean for fixed income investors? For one, it cautions our team on adding too much duration too soon. We would rather be late to the party and forego early returns than show up at the wrong house and have the police called (or worse!). In addition, a “higher for longer” Fed should also support assets that are priced on the front end of the curve—instruments like short duration and floating rate bonds, loans, etc. As we’ve said before, there will come a time to add duration, but we still believe it is further out in the future than most.

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