Fed Chairman Jerome Powell’s new preferred measure of inflation for service sector prices accelerated in January, adding to the case for rate hikes. Broader inflation measures also came on the hot side as consumer spending surged to start 2023, sending the S&P 500 below a key support level.

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Three rates of PCE inflation

The index of total personal consumption expenditures, or PCE, rose 0.6% in the month and 5.4% from a year ago. Wall Street had expected a monthly rise of 0.4%. The 12-month PCE inflation rate was expected to decline to 4.9%.

Core personal consumption expenditures inflation, which excludes volatile food prices and inflation, rose 0.6% month-on-month, versus expectations of 0.4%. Core inflation rose to 4.7%, defying expectations that it would drop to 4.3%.

Hot inflation readings for January looked worse due to upward revisions to price data for December which was initially seen as muted.

The Fed usually emphasizes the inflation rate of core personal consumption expenditures. But with commodity prices falling as demand normalizes after the pandemic surge and housing costs expected to follow later this year, Powell sharpened prices for essential non-residential services as a key to the inflation outlook. That’s because prices for services from hair cutting to health care and hospitality correlate closely with wages, and are generally the largest cost inputs.

In January, prices for core personal consumption expenditure services excluding housing rose 0.6% month-on-month, the fastest since November 2021, and 4.65% from a year ago. The 3-month annual inflation rate rose to 5.3%.

The December PCE inflation report showed a 4.1% 12-month inflation rate for Powell’s non-residential essential services category. At the time, it looked like inflation pressures in the services sector might have passed their peak. But after upward revisions to December and Q4 data, a steady decline in inflation looks less certain.

Standard & Poor’s 500 reaction

After the PCE spending and inflation report, the S&P 500 fell 1.3% early Friday in stock market action. So far, the S&P 500 has largely held its gains over the past few weeks, despite hot economic data and higher Treasury yields. The S&P 500 has so far found support at the 50-day moving average, but fell below it early on Friday, which could herald further weakness.

As of Thursday’s close, the S&P 500 was 16.35% below its record close high, but up 12.2% from the bear market’s closing low on Oct. 12.

The 10-year Treasury yield rose 6 basis points, to 3.94%.

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What does the PCE report mean for the Federal Reserve?

Since the February 3 jobs report showed strong hiring and low unemployment, financial market prices have undergone an abrupt turnaround. Prior to that, markets had expected the Fed to raise less than official expectations and start cutting interest rates later this year. After the PCE inflation report on Friday, so were the markets Pricing at odds of 88.5% That the Fed will raise its key interest rate to a range of 5.25% to 5.5% by late July meeting. That means one additional increase compared to the Fed’s latest forecast.

In addition, the odds of a 50 basis point rise on March 22nd rose to 39% shortly after the PCE inflation data. More strong inflation data and a strong jobs report could prompt the Fed to take a half point move.

Inflation expectations may not be as bad as they suddenly seem. Wage growth appears to have slowed, which should dampen service sector inflation over time. However, the Fed has two reasons for continuing to raise interest rates that may dictate policy in the near term.

First, Fed officials believe that the costs of not rising enough, which can lead to entrenching inflation, are far greater than the costs of rising too much. Second, until recently, Fed officials have largely failed to convince markets that interest rates will rise and they will stay there for much longer. That had consequences. Treasury yields fell, lowering borrowing costs and helping to give the economy a second boost.

Now that the markets have finally heard the Fed, it is likely that policy makers will not want to raise interest rates by an amount less than the markets are betting.

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