Personal Consumption Expenditures Price Index (PCE) vs. Consumer Price Index (CPI)
2022 will forever be remembered as the year of inflation.
Markets, interest rates, and central bank policies have all been effected.
Americans are feeling the pain when purchasing gas or going to the grocery store. Every day there is a new headline, with a new price or inflation record high.
Did you know that the Federal Reserve monitors the PCE index? Did you know that the core PCE Index does not include the rising costs of energy nor the price of food?
In 2012, the PCE Price Index became the primary inflation index used by the Federal Reserve in determining monetary policy decisions. This decision was made as the PCE Index is composed of a broad range of expenditures acquired through business surveys, which tend to be more reliable than consumer surveys. Secondly, the PCE Index uses a formula that allows for adjustments in consumer behavior in the short term. In comparison, the CPI Index is produced using consumer sources. CPI does includes both food and energy; and both of these inputs have tremendous volatility (relative).
There are other differences in the two indexes and they do tend to behave differently over time. The formula, relative category weights, scope of information, and other effects (seasonal-adjustment differences, price differences, residual differences) also factor into different outcomes. For example, in the fourth quarter of 2010 there was a difference of 0.9%1 (2.6% vs 1.7%). As of today, CPI is at 8.6%2 (May 2022) year-over-year versus the Core PCE at 4.9%3 (April 2022). The CPI Index for April was 8.3%2 (Core PCE 4.9%3) for comparison purposes. The Federal Reserve decided that using the PCE index to factor monetary policy is advantageous due to less overall volatility and more reliable information. However, critics will argue that energy and food costs should be considered in policy actions.
WHY DOES ALL OF THIS MATTER TO MY PORTFOLIO?
One of the main policy actions by the Federal Reserve to combat inflation is raising interest rates. Interest rate increases have a negative effect on both stocks and bonds. From 2015-2018, the S&P 500 dropped an average of -0.4%4 the day the Federal Reserve increases rates and -0.9%4 the in the next month. In 2018, the Fed moves were coupled with pronounced volatility. Four rate hikes were followed by: +3.8%, -5.4%, -8.5%, and +6.6%4 monthly returns. As for bonds, the volatility depends on the duration of the bond. Duration is a measure of sensitivity of the price of a bond to a change in interest rates. For example, the US Aggregate Bond Index (as measured by AGG ETF) has an effective duration of 6.785. That means the price of the portfolio will move conversely to a +/-1% shift in rates by +/-6.78%.
HOW DO RISING INTEREST RATES AFFECT BONDS?
Bonds and interest rates have an inverse relationship. If interest rates rise, investors will prefer higher paying bonds. Investors then sell the lower paying bonds, driving down those bonds prices.
HOW DOES THE FEDERAL RESERVE AFFECT THE BOND MARKET?
The Federal Reserve controls the federal funds rate. The federal funds rate is the target rate at which commercial banks borrow and lend their excess reserves to each other overnight. This influences short-term rates on consumer loans, credit cards, and new bond issues. If new bond issues must keep up with the federal funds rate to create demand, lower paying bonds are sold pushing down those bond prices.
HOW DOES THE FEDERAL FUNDS RATE AFFECT INFLATION?
In general, when interest rates are high, the economy slows and inflation decreases. But why? If rates are high, consumers have less money to spend. Investors tend to save more because savings returns are higher. Additionally, loan demand decreases as borrowing costs increase.
SHOULD I ASSUME THAT THE 10-YEAR TREASURY WILL INCREASE ALONG WITH THE FEDERAL FUNDS RATE?
Normally the 10-year treasury yield is a precursor to expected increases in the federal funds rate. It will move ahead of the Federal Reserve and set market expectations. Historically rates have actually decreased after fed funds rate escalation. For two reasons: (1) Bond markets have a tendency to overprice actual Federal Reserve policy changes, (2) Investors expect economic growth to slow with higher rates and move to safer assets.
HOW DO RISING INTEREST RATES AFFECT STOCKS?
Generally speaking, rising interest rates are not welcomed by stock investors.
By raising interest rates, the Fed is increasing borrowing costs
Rising interest rates would encourage people to save more with higher savings yields
Credit card and other variable debt payments become more expensive slowing demand due to less consumer liquidity
Decreasing money supply in the system means a slower economy and less inflation
Dividends and Earnings are discounted to the new increased interest rates
Usually Federal Reserve interest rate hikes take 12 months for widespread economic impact
ARE ALL EQUITY SECTORS AFFECTED EQUALLY?
No, some sectors actually benefit such as financials. In contrast, high valuation firms (or firms without positive earnings) feel the greatest negative impacts.
DO RISING RATES AFFECT CORPORATE EARNINGS?
Yes, if consumers have less disposable income to spend sales and profits may be hindered.
As the economic cycle progresses it is necessary for the Federal Reserve to raise interest rates. This happens every few years. Mechanically, the bond and stock markets both anticipate the Federal Funds Rate. The Federal Reserve uses interest rates to either cool an economy or to help stimulate an economy when in an economic downturn. Today, the Federal Reserve finds itself in a predicament where combating high inflation is the main concern. As rates rise, money becomes more expensive to obtain and the supply of money in the economy shrinks. Less money supply reduces corporate profits, reduces the purchasing power of the consumer, and slows the overall economy.
