Core PCE Inflation Expected to Decline on Deeper Read of CPI/PPI

As investors analyze the latest inflation data, a key shift in expectations for core Personal Consumption Expenditures (PCE) inflation is emerging. While the Consumer Price Index (CPI) came in hotter than expected earlier this month, the Producer Price Index (PPI) components that feed into PCE suggest a softer inflation reading ahead.

Economists now anticipate that January’s core PCE inflation, due for release on February 28, will show a decline to 2.6 percent year-over-year from 2.8 percent in December, largely due to weakness in healthcare and insurance costs, as well as lower airline fares. If this materializes, it would provide a more favorable inflation outlook than initially feared, potentially shaping the Federal Reserve’s policy trajectory for 2025.

Why Core PCE Matters More Than CPI

Federal Reserve Chair Jerome Powell recently reaffirmed that the central bank primarily targets PCE inflation, rather than CPI, when assessing price stability.

- CPI tends to be more volatile, reflecting short-term swings in energy and food prices, whereas PCE provides a more stable measure of underlying inflation trends.

- PCE assigns different weightings to consumer expenditures, particularly in services and healthcare, which often result in a more subdued inflation reading compared to CPI.

Given that core CPI for January came in at 0.45 percent month-over-month, significantly above expectations, the anticipated lower core PCE print offers a more encouraging picture for disinflation progress.

Breaking Down the Key Drivers of Core PCE Decline

1. Softer Healthcare and Insurance Prices

Healthcare-related services account for a significant portion of the PCE basket, and recent PPI data revealed notable weakness in these components.

- The health insurance category, which has been a persistent source of inflationary pressure, saw a decline in January’s PPI data.

- Medical services and hospital costs also showed signs of stabilization, easing some of the price pressures in the broader economy.

2. Decline in Airline Fares

- Airline prices, which had been a contributor to inflation spikes in 2023, dropped sharply in January, reflecting weaker seasonal demand and lower fuel costs.

- Given travel-related expenses hold a meaningful weight in PCE, this development adds to the disinflationary trend.

3. PPI’s Direct Impact on PCE

- Many financial services and corporate-sector expenses are directly reflected in the PCE calculation.

- As PPI data for these components was softer than expected, core PCE will likely show a milder inflation reading than CPI, reinforcing a more dovish outlook for the Federal Reserve.

What This Means for the Federal Reserve’s Rate Path

The anticipated decline in core PCE strengthens the case for rate cuts in 2025, though Powell and other Fed officials have emphasized the need for consistent disinflation before making any policy adjustments.

- Fed officials have been cautious about reacting to one or two months of data, as Powell reiterated recently.

- However, if core PCE continues to track lower, it would reinforce expectations that the Fed can begin cutting rates in the second half of 2025.

Markets are currently pricing in two rate cuts for 2025, and a subdued PCE print could further solidify this outlook.

Market Reactions and Investment Implications

Fixed Income Market

- A cooler PCE print would support lower Treasury yields, as expectations for rate cuts strengthen.

- Investors in bonds and fixed income securities may see renewed demand for long-duration assets, particularly if inflationary pressures continue to ease.

Equities and Risk Assets

- A declining inflation trend is bullish for equities, particularly in growth sectors like technology and consumer discretionary.

- Lower interest rates enhance equity valuations by reducing discount rates on future earnings, making rate-sensitive stocks more attractive.

US Dollar and Commodities

- If PCE inflation trends lower, the US dollar could weaken, as lower inflation reduces the need for higher interest rates.

- A softer dollar could support gold and commodity prices, which tend to move inversely to the dollar.

Final Thoughts: A Favorable Inflation Outlook Could Confirm Rate Cut Timing

The upcoming core PCE inflation report is shaping up to be a key data point for Federal Reserve policy in 2025. While January’s CPI print created concerns about sticky inflation, the underlying components of PCE tell a more encouraging story.

If core PCE tracks at or below the expected 2.6 percent year-over-year level, it would reinforce the narrative that inflation is gradually returning to the Fed’s 2 percent target, increasing the likelihood that rate cuts will commence in the second half of 2025.

For investors, the outlook for lower inflation supports a constructive stance on equities, bonds, and risk assets, though continued vigilance on economic data remains essential.