The Federal Reserve’s August report on personal income and outlays has added further fuel to speculation that inflation is beginning to ease in the United States.
The report highlighted that the annualized Personal Consumption Expenditures (PCE) price index, the Fed’s preferred inflation index, had risen just 6.2 percent since last August, down from 6.4 percent through July and 7.0 percent in June. While a far cry from the 1-2 percent inflation rates that the Fed targeted before the pandemic, this latest data point is an encouraging sign that the central bank’s consecutive increases in the cash rate may be starting to have an effect. That is, of course, good news for the Fed, which has made it clear that it is more than willing to ramp up borrowing costs in order to cool off the economy and bring inflation under control.
Still, with unemployment high and economic growth likely to remain muted in the near term, it is far from clear that inflation will remain contained. While the headline PCE figure suggests that inflation is easing, it’s important to consider the context. To help put things into perspective, let’s take a look at the data around inflation in more detail.
Is PCE Reliable?
One of the most common complaints economists have about metrics like the headline PCE is their tendency to be skewed by volatile price swings on key goods. In this case, major price declines in foodstuffs and/or energy products can give the impression of moderated price increases and easing inflation.
To get a better sense of underlying inflation trends, economists typically recommend either down-weighting energy and food prices from headline measures or using so-called core inflation indices that exclude these items altogether.
When looking at the core PCE figure for August, we are greeted with a less rosy picture. While the overall PCE index may have slowed year-to-year, core PCE shows a month-to-month rise of 0.2 percent relative to July (that translates to a 4.9 percent rise from August 2021)
So, what does this mean? In short, it means that the price of basic goods and services is still on the rise. While gasoline and certain key food products (i.e., wheat and vegetable oil) have dropped significantly from the high prices seen earlier this year, other categories have not seen the same relief. For instance, the cost of medical care, new vehicles, and rent have all continued to increase. Overall, this means that Americans are still feeling the squeeze from rising prices and decreased purchasing power, despite some softening in the headline data.
How Are Investors Responding?
An inflationary environment poses both risks and opportunities for investors. While rising prices can eat into the purchasing power of cash holdings, a steeper yield curve can also provide a tailwind for certain asset classes. After years of ultra-low rates, we are starting to see yields creep up, which is starting to attract more attention from income-seeking investors. In this environment, dividend stocks and other high-yielding assets may start to look more attractive.
While many economists are optimistic about the gradual trend of inflation subsiding, institutional investors remain skeptical. With the US still grappling with the highest inflation rates in four decades, retail and retirement funds are adjusting their allocations to broaden their exposure to gold and other precious metals (widely regarded as safe haven assets in an inflationary environment). On the other end of the spectrum, cash-rich hedge funds and institutional investors are starting to get more aggressive in their investment strategies, with many looking to capitalize on increased volatility and arbitrage opportunities.
Thanks to the rise of online trading platforms like Easymarkets, it has never been easier for retail investors to access these same strategies. By understanding the data and being thoughtful about your investment decisions, you can position yourself to weather the storm, limit your downside, and come out ahead.
The Bottom Line
Inflation can be a tricky phenomenon to wrap your head around. Between the vast quantities of financial jargon and the often-confusing statistical metrics, it can be hard to get a grasp on what’s really happening. To help make sense of all the noise, it’s always worth digging into the data. However, it’s important to keep in mind that inflation is a lagging indicator. This means that it can take months or even years for inflation to catch up to changes in the wider economy.
While indicator metrics like PCE have shown signs of easing in recent months, inflation is still significantly elevated relative to historical norms. With central banks around the world signaling their intention to continue with gradual monetary tightening, prices are unlikely to drop any time soon. Investors should be prepared for continued market volatility and adjust their asset allocations accordingly.
