Market Professionals Seek Supercore Inflation, Ignoring Core CPI

Prices for services are increasing rapidly, while prices for goods are falling. Energy prices are all over the map. Policy makers and market watchers strip out volatile components of price indexes to understand “core” inflation. These days, many are looking for an even narrower measure: a supercore.
The Labor Department's latest inflation reading is due out on Thursday, and most investors will be closely watching the monthly change in the core consumer-price index. The core CPI excludes food and energy categories, providing a better sense of inflation's longer-term trajectory.
Some people will quickly look past the number of homeless people to metrics such as core services excluding housing—or even core services excluding housing and medical care. And even that won’t be entirely satisfying.
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The root problem for investors is that inflation has become more complicated. Core goods inflation has turned negative in recent months, thanks to increased supply of many products and reduced demand. But services inflation has remained elevated—the result, many argue, of a stubbornly hot jobs market and escalating labor costs.
"I think it was pretty clear last year that CPI was the major focus for markets, because we continued to get such shocking numbers to the upside," said Roger Hallam, global head of rates at Vanguard.
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Now, the analyst said, when the CPI report is released, "the goods and shelter print will get less relative focus compared to what's happening on the services side of things" - and, as the year goes on, "the market will transition towards a greater focus on the labor-market numbers."
In recent months, Federal Reserve Chairman Jerome Powell has emphasized the importance of core services excluding housing. This is in line with the Fed's preferred inflation gauge, the personal-consumption expenditures price index. This index is not released until the end of each month, but it has been more accurate than the CPI in recent months.
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Adding an extra layer of complexity, Mr. Powell has helped convince many investors that the labor market is the key to understanding the direction of inflation, making inflation data itself arguably less important.

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The recent focus on alternative measures of economic activity has led investors to look beyond traditional indicators like the unemployment rate. However, this has created its own set of challenges, as each of these new metrics has its own drawbacks.
Investors have become less worried about inflation in recent months, as evidenced by recent market moves. This suggests that they believe the inflation threat has narrowed.
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Yields on U.S. government bonds peaked last October, reflecting investors' expectations for short-term interest rates set by the Federal Reserve. At that time, data had not yet shown a drop in core goods prices, even as it was indicating an acceleration in services inflation.
Since then, yields have fallen significantly, with core inflation for durable goods over the past three months running at an annualized rate of -1.9%.
Investors are optimistic about the pace of wage gains in recent months, after last Friday's jobs report showed less than expected growth in average hourly earnings. The report also included downward revisions to the gains from previous months, which is good news for Wall Street.
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The yield on the benchmark 10-year U.S. Treasury note fell to 3.618% on Tuesday, down from its peak of 4.231% in the fall.
For investors, a big question now is how much to worry about the persistence of high services inflation. There is also a question about how much stock to put into the monthly wage data, given its large swings in recent months. Overall, core PCE prices climbed at a 3.6% annualized rate over the three months ended in November, still well above the Fed’s 2% target. However, some economists believe that the recent rise in inflation is due to one-time factors and that it will soon start to moderate.
Fed officials have mostly expressed continued concern about the inflation outlook. They have noted that inflation remains below their 2 percent target, and they have signaled that they are prepared to take action if it begins to rise.
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The minutes from the Fed's December meeting, released last week, showed that officials are still focused on core services excluding housing. They noted that housing is the largest component of core PCE inflation and are worried that investors might underestimate their resolve to hold interest rates at higher levels, leading to "an unwarranted easing in financial conditions."

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One measure of labor-market tightness that Fed officials have highlighted showed little sign of cooling in a report last week. The number of job openings held near historically high levels.
The Labor Department will release its quarterly employment-cost index later this month, which is widely seen as the most reliable gauge of worker pay. This will help to resolve some of the confusion around wages.
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Investors are closely monitoring the Fed's statements on inflation and the labor market. If not, bonds could have seen even more gains, analysts said.
According to Jim Caron, a fixed-income portfolio manager at Morgan Stanley Investment Management, the service sector is receiving more attention from investors today due to the Federal Reserve's current policy stance. Caron notes that the Fed's policy-reaction function is skewed towards the service sector, meaning that it is more responsive to changes in this sector than others.
Some investors and analysts question the Fed's argument that a tight labor market will inevitably keep services inflation elevated and therefore overall inflation at unacceptably high levels.
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Omair Sharif, president of research firm Inflation Insights LLC, said that one factor behind high services inflation last year was a surge in airline fares, partly due to increased fuel costs.
Mr. Sharif prefers to measure services inflation by stripping out energy, housing, medical care, and transportation categories. This gauge has shown a less alarming trend in the rate of price increases.
The Fed's focus on core PCE housing is driven by their belief that wage pressures are closely linked with core services, according to one analyst. However, it is unclear to what degree this is actually true.