Inflation: Subject to change

Quick read:

• The deceleration of the core PCE (Personal Consumption Expenditures) inflation rate in the second half of 2023 catalyzed a pivot in monetary policy messaging and shifted market pricing for the path of policy rates in 2024.
• However, the propensity for core PCE to be revised upward and the growing wedge between core PCE and other measures of inflation (like the core Consumer Price Index) makes us hesitate to read too much into this initial estimate of the data.
• In our tactical multi-asset portfolios like the BlackRock Tactical Opportunities Fund, we remain short duration and have been reducing exposure to US Treasuries versus non-US government bond markets.

One piece of data I will be watching closely is the scheduled revisions […]. Recall that a year ago, when it looked like inflation was coming down quickly, the annual update to the seasonal factors erased those gains. In mid-February, we will get the January CPI report and revisions for 2023, potentially changing the picture on inflation. My hope is that the revisions confirm the progress we have seen, but good policy is based on data and not hope. – Fed Governor Waller “Almost as Good as it Gets…But Will It Last?”, January 16, 2024

Inflation declined much more quickly than expected in 2023. The Fed’s preferred inflation measure, core PCE, appears to be running at close to the 2% target in the second half of last year. This catalyzed the shift in monetary policy messaging in December 2023, and markets have subsequently gone on to price more than five interest rate cuts for 2024. However, as we analyze the totality of the US inflation and growth data entering 2024, we share the caution voiced by Fed Governor Waller in his recent speech.

As the saying goes, you only get one chance to make a first impression. However, that adage doesn't apply as much to inflation data. Short-term measures of inflation are very noisy and PCE is particularly subject to change. Given the heightened importance of the inflation trajectory for bond markets following three years of above-target price increases, we note two important features of the data:

• First, the initial release of core PCE tends to be biased downward, historically by about 20bps annualized. This means that we should be cautious about the initial soft reading of Q3 and Q4 data since they are prone to be revised upward in the coming months.¹
• Second, while it is normal to see a wedge between core CPI and core PCE, the two measures have recently been moving in different directions. When this occurs, we have historically found that core PCE tends to be even more prone to upward revisions.

What’s up with inflation revisions?

Revisions are one source of noise in short-term inflation measures. Revisions occur throughout the year as statistical agencies incorporate additional data sources – like tax filings – into their preliminary estimates of national activity. The plot below shows revisions to core PCE inflation, highlighting both the frequency and magnitude of revisions.

Notably, upward revisions have been more frequent and sizable in the post-pandemic reopening period. We find that revisions to quarterly core PCE since the Q1 2021 reopening have averaged +36bps and multiple quarters have had upward revisions of over 1%. The near-term trajectory of inflation can look very different in the aftermath of many of these revisions. As noted by Waller, nascent downward trends can disappear altogether with the incorporation of additional information.

Core PCE is a moving target

Our analysis of historical core PCE revisions also reveals a few interesting dynamics about the nature of revisions, which further contribute to our view that upward revisions are likely:

• Upward revisions tend to originate in core services, which currently account for 75% of the core PCE consumption basket. Services prices that are difficult to measure or episodically reset – such as financial services, insurance, and professional services – have been contributors the recent upward core inflation revisions.
• Revisions tend to be procyclical with changes in national activity. That means that when the economy is doing well, as has recently been the case, core PCE revisions tend to be more prone to upside revisions.
• Initial revisions in the first six months have historically been negatively correlated with the revisions in the subsequent six months. If this pattern holds, we should expect upward revisions to the core PCE trajectory in second half of 2023.

Alternative measures of inflation

To complement our analysis of traditional data, our team computes our own alternative inflation measures to help to reduce the noise and idiosyncrasies contained in any single measure of price changes. Examples include down-weighting or excluding any sub-component within the overall price index that exhibits excessive volatility, not just food and energy as is the norm with standard core inflation measures. This can be especially helpful for moments like this when the two main measures of core inflation – PCE and CPI – diverge. In the plot below, we show the annualized quarterly run rates of all three of these inflation measures. This visual shows that the moderation of PCE is anomalous relative to other two measures that have continued to track above 3% in recent quarters.

Core PCE has diverged from other measures of inflation

Finally, more tactically and separate from the question of revisions, we believe geopolitical fragmentation and the recent shipping disruptions in the Red Sea and Panama Canal could reverse some of the goods price declines that powered the disinflation in 2023. Taking all of this together, we share Governor Waller’s concern of “will it last?” as it pertains to the recent trajectory of PCE inflation.

What do these views mean for portfolio positioning?

In our tactical liquid alternative portfolios like the BlackRock Tactical Opportunities Fund, we seek to deliver returns that are lowly correlated with stock and bond markets. We use macro data related to growth, inflation, policy and market pricing to seek out long and short investment opportunities across countries and asset classes.

Our insights on inflation and core PCE revisions help to inform our directional underweight positioning in global duration. They also contribute to our recent rotation within the portfolio to be shorter US Treasuries versus other government bond markets, as market pricing appears misaligned with the otherwise resilient activity data in the United States.