January 2025 Core-Cast Post- PCE: Small Upside Surprises and Three Lagged Quirks That Stand In The Way Of The Fed's Target

Skanda Amarnath -

Core-Cast is our model and publication series for nowcasting the Fed's Personal Consumption Expenditures (PCE) inflation gauges. Most of the PCE inflation gauges are sourced from Consumer Price Index (CPI) data, but Producer Price Index (PPI) input data is of increasing relevance, import price index (IPI) data can prove occasionally relevant. There are also some high-leverage components that only come out on the days of the GDP and PCE releases.

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Summary: PCE Nowcasts

Our month-over-month Core PCE Nowcasts were reasonably accurate relative to today's final release, but the allocation of revisions with Q4 surprised to the upside and thus push year-over-year Core PCE inflation another 4 basis points higher and meaningfully higher than our nowecasts after PPI.

These revision modeling errors relate in part to (1) the partial seasonal factor revisions in the CPI (PCE only absorbs the final three months of revisions, with the previous 9 months of 2024 only revised in September 2025), and (2) some of the excess upside we anticipated in December getting revised back in. If you remember from last month, we were nowcasting 20-21bps in the final week of the nowcasting cycle; the data was ultimately revised to 21bps.

With knowledge of the allocation of upside revisions to Q4, this January Core PCE reading looks less impressive to the Fed and only seems to undo the increased year-over-year readings in Q4. As a result, the Fed will have to proceed more cautiously and if there is indeed a path to a May interest rate cut (not our base case but plausible), it is marginally narrower now.

Discussion

While the CPI seasonal factor revisions distorted some of the year-over-year readings in this PCE release, the overall picture is reasonably consistent with what we saw last month. Most of the overshoot vs the Fed's 2% inflation target boils down to three lagged quirks. If not for those quirks, Core PCE inflation would be 2.18%, within spitting distance from the Fed's target

(1) Housing lags (>21bps excess contribution): The measures of rent and owners' equivalent rent inflation substantially lag market rent dynamics. While market rents continue to show tepid growth and drastically slower growth rates for new tenants than what we saw in 2021, the CPI housing survey (used for calculating housing CPI & PCE inflation) looks at the universe of contracted rents across all tenants. As a result, housing CPI & PCE inflation has taken much longer to slow down and is still decelerating. With labor income growth fully normalizing, housing inflation is primed to decelerate further and hit more normal growth rates similar to what we saw prior to the pandemic.

(2) Wage cost lags (~16bps excess contribution): There are an array of PCE components that are measured using opaque "input cost indices" that are intended to track primarily the labor cost of performing those activities. These indices tend to behave similarly to wage growth at a macroeconomic level, albeit with some lag. Wage growth at a macroeconomic level tends to be lagging too, especially to labor turnover dynamics. A low and falling "quits" rate implies wage growth is also poised to decelerate.

(3) Financial Market Lags (~12bps excess contribution): The equity market's strong run in the past 14 months has also been a strong tailwind to measured financial services PCE inflation. If the stock market shows more signs of moving side ways as we are currently seeing, we could easily see another 6-7 basis points roll off of the Core PCE year-over-year reading.

These lagged quirks add up to at least 49 basis points of overshoot that should roll off over time. That alone would not get us all the way back to 2% PCE inflation, but would put us firmly in the margin of error.

Of course, even as this discussion focuses on lagged quirks, it's increasingly plausible that new sources of price increases could flare up again. Among them, are the array of goods and services exposed to surging commodity prices (e.g. coffee, eggs) and tariff risks (both goods and a variety of goods-adjacent services).

The Fed is also likely to contend with some of the supply side costs of its own tightening policies. Finance-intensive sectors like housing and energy have seen more tangible impacts from the Fed's broader tightening campaign, with some of that reduced capital formation liable to stoke a firmer pick up in prices later. Market rents will likely only accelerate materially in 2026, but it's possible we see acceleration later this calendar year. If so, a 2026-27 reacceleration of housing inflation seems more plausible for supply-side reasons.

New risks of shocks are clearly on the Fed's mind, such that merely hoping for lags to roll off is no longer sufficient for analyzing and projecting the inflation trajectory.

Inflation Overshoots At The Component Level

For the Detail-Oriented: Core PCE Heatmaps

Right now Core PCE (PCE less food products and energy) is running at a 2.65% year-over-year pace as of January, 65 basis points above the Fed's 2% inflation target for PCE. That projected overshoot is disproportionately driven by catch-up rent CPI inflation in response to the surge in household formation (a byproduct of rapidly recovering job growth) and market rents in 2021-22. Rent is on track to contribute 21 basis points to the 65 basis point Core PCE overshoot.

There are other contributors to the overshoot:

  • Measured financial service charges now likely adding 12 basis points due to the strong equity market performance over the past 12 months.
  • Contributions from input cost indices (wages in specific sectors where market prices don't exist) are now adding 16 basis points to the overshoot
  • Food price dynamics are likely adding 5 basis points to the overshoot
  • Motor vehicle dynamics are likely adding 2 basis points
  • In-person recreation and lodging services are contributing 6 basis points
  • Discretionary goods and adjacent services are adding 10 basis points

The final heatmap below gives you a sense of the overshoot on shorter annualized run-rates. January monthly annualized Core PCE ran at a 3.47% annualized pace, a 147 basis point overshoot vs 2% target inflation.

For the Detail-Oriented: Core Services Ex Housing PCE Heatmaps

The January growth rate in "Core Services Ex Housing" ('Supercore') PCE ran at a 3.09% year-over-year pace, a 51 basis point overshoot versus the ~2.59% run rate that coincided with ~2% headline and Core PCE.

January monthly supercore ran at a 2.69% annualized rate, a 10 basis point annualized overshoot of what would be consistent with 2% Headline and Core PCE.