US Bonds Eye Softer Inflation After Core PCE Undershoots Forecasts

During the U.S. session on Wednesday, we have gotten a couple of important economic announcements, including the ADP nonfarm employment change, the core PCE price index number, the final GDP, and the final GDP price index, all coming out of the United States. These are numbers that traders are reacting to as underlying inflation came in below expectations. This is a bit of a surprise, and one that will catch the market’s attention in this environment.

Second-quarter growth was revised a little bit higher, and private-sector hiring has improved. Together, the reports suggest an economy that continues to expand without a corresponding acceleration in the latest monthly core inflation reading. For markets, the central question will be whether or not the balance can persist, allowing the Federal Reserve to contain inflation without imposing additional pressure on growth via rates.

That Distinction Matters

August core personal consumption expenditures price index rose by 0.2% month over month and 3% year over year. Forecasts were for 0.3% month over month and 3.3% year over year, respectively. July’s monthly increase was revised to 0.1%, meaning August’s reading was softer than expected, but actually faster than the preceding month.

A favorable surprise against forecasts does not necessarily mean inflation slowed on every measure. Core PCE measures food and energy apart from other price pressures. So, despite the fact that households still face those expenses, the broader inflation picture remains less comfortable. This is a problem, but the slight relief will be welcomed by market participants, as inflation has been the topic du jour.

Reuters reported that headline PCE increased 0.3% in August and 3.4% year over year, but this should not be interpreted as evidence that the overall cost-of-living problem has disappeared. This is just a strong first step in what would need to be many to change things in this area.

Growth in America Remains Resilient

The growth report, as far as GDP is concerned, suggested that economic activity remains resilient. The third estimate of second-quarter real GDP showed annualized growth of 2.2%, compared with the previously published 1.5%, with consumer spending increasing at a 3.8% annualized pace, while real final sales to private domestic purchasers rose 4.6%.

The latter number combines consumer spending with private fixed investment and helps assess domestic demand between fluctuations in trade, inventories, and government activity.

The employment report offered a more recent signal. ADP estimated that private-sector employment increased by 90,000 in September, exceeding the 70,000 forecast in the survey. August’s gain was revised down to 36,000 from 38,000. Hiring, therefore, did improve, although the downward revision slightly tempered the comparison.

The combination reduces the immediate tension between growth and inflation rather than resolving it. Stronger demand and hiring can support spending and corporate revenues, but they can also cause sustained price pressures. A single favorable core inflation reading offers a little bit of breathing room, but it does not establish a durable return to price stability.

For bonds, softer inflation can reduce the compensation investors demand for future price increases and lower rates. That is a particularly important part to pay attention to at the moment. This is an area that has been the main driver of everything lately, even more so than usual, especially when thinking about energy inflation.

The next test will be whether or not subsequent employment and inflation reports confirm this balance, with the nonfarm payroll number coming out on Friday. This is crucial, because if a pattern is detected, it could have traders placing bets in the future of the US, the US dollar, and risk appetite.