What’s Really Driving Inflation Right Now?

The latest minutes from the Federal Reserve’s July meeting underscored how important upcoming inflation and labor market data will be for future interest rate decisions. The Fed voted to keep its benchmark Federal Funds Rate unchanged, although three policymakers dissented in favor of a quarter-point hike. The minutes also showed that “many participants” believed rate hikes could be appropriate if inflation fails to decline.

A closer look at the latest Personal Consumption Expenditures (PCE) inflation data, however, suggests there are some important reasons to question whether higher rates would address the inflation consumers are actually experiencing.

Inflation Isn’t Broad Based

There was some encouraging news in the latest report. Headline PCE rose 0.16% in July, in line with expectations, leaving the annual inflation rate at 3.7%. Core PCE, which excludes food and energy prices, rose 0.24% for the month, while the annual core inflation rate remained at 3.3%.

That’s still well above the Fed’s 2% target. But the details tell a different story.

Most of July’s core inflation came from just four categories: shelter; healthcare; video, audio and photographic equipment; and portfolio management.

Shelter prices rose 0.26% in July and healthcare costs increased 0.2%. Because these categories make up a significant share of core PCE, their monthly changes matter. Together, they contributed about 0.09 percentage points to July’s 0.24% core inflation reading.

Video, audio and photographic equipment prices jumped 1.5%, contributing about 0.04 percentage points. Higher chip costs and demand related to AI appear to be playing a role.

The biggest contributor, however, was portfolio management. Prices in that category rose 5.6% in July, adding about 0.12 percentage points to monthly core PCE – roughly half of the entire increase. That figure deserves a closer look.

Portfolio Management Is Skewing Inflation

Portfolio management is different from many of the goods and services consumers typically think of as inflation.

Think about it this way: If your investment portfolio rises in value, the amount you pay a financial advisor may also increase if their fee is based on a percentage of your assets. But the advisor hasn't necessarily raised their fee. You're simply paying more because your portfolio is worth more. In fact, you're likely happy to pay the additional fee because your investment has gained value.

That makes this measure different from the price increases consumers typically think of as inflation. Yet it can still push the PCE inflation reading higher.

The Bureau of Economic Analysis (BEA) has already announced that it will change how portfolio management fees are calculated in the PCE report beginning with the August data, which will be released September 30. Until then, this category is arguably overstating the underlying inflation picture.

The impact is significant. Portfolio management is contributing nearly 0.5 percentage points to the year-over-year core PCE rate. Without it, core inflation would be closer to 2.9% rather than 3.3%.

And there’s another important point: the four categories discussed above contributed roughly 0.25 percentage points to July’s core inflation rate, compared with the reported 0.24% increase.

That means virtually all of July’s core inflation came from these four areas. Prices across the rest of the economy were essentially flat in aggregate.

Consumers are still feeling the effects of inflation because higher prices accumulate over time. But the latest data suggests that prices are not currently rising broadly across the economy.

Would Higher Rates Fix the Problem?

Some policymakers have suggested that another rate hike could be appropriate if inflation doesn't move closer to the Fed's 2% target. But higher interest rates wouldn't directly address the categories driving the latest inflation increase.

Higher rates aren't going to lower shelter costs, healthcare prices, chip costs or portfolio values. Instead, they could put additional pressure on consumers and the broader economy – and consumers are already under strain. A rate hike would make credit cards, auto loans and other variable-rate debt more expensive.

There was some good news in the latest report: incomes rose 0.4%, slightly better than expected, and the personal savings rate increased from 2.6% to 3%. But that improvement comes after the savings rate fell to a multi-year low. Higher borrowing costs could put additional pressure on household finances and make it harder for consumers to rebuild their savings.

The broader economy also doesn't appear strong enough to easily absorb another rate increase. The second estimate of second-quarter GDP showed the economy grew at a 1.5% annualized rate, unchanged from the initial estimate and in line with expectations.

Growth below 2% isn't particularly strong, especially when consumers are already feeling financial pressure. Another rate hike could slow economic activity even further.

The Fed's challenge, then, is balancing two risks: inflation that remains above its target and an economy that is already losing momentum. The latest PCE data suggests that inflation is not broadly accelerating. Instead, much of the recent increase is concentrated in a handful of categories, and one of the biggest contributors may be overstating underlying inflation.

That should give the Fed reason to look closely at the underlying details before deciding whether another rate hike is the best way to bring inflation closer to its 2% target.

By The MBS Highway Team