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The Tell: ‘Burden of proof’ is on inflation optimists after Fed’s preferred inflation gauge fails to calm markets

The latest reading from the Federal Reserve’s favorite price gauge, which contains some signs of cooling, is failing to calm the nerves of traders and investors who are fretting about a possible recession, higher interest rates and inflation that’s simply not coming down fast enough.

U.S. stocks fell off sharply Thursday morning after the release of May’s inflation data, while investors flocked to the safety of Treasurys in a classic risk-off response to fears of slowing growth. But economists say it’s not just concerns about an economic contraction that are weighing on markets, pointing to still-worrisome signals in Thursday’s inflation report.

While the initial take from the release of May’s so-called personal-consumption price index was focused on signs of easing price pressures in the narrower core measure, which excludes food and energy, the overall monthly PCE reading still rose 0.6% last month and was triple the 0.2% gain in April. In addition, the headline rate of inflation over the past year was unchanged at 6.3%.

“There might be a sense of victory for some that things are improving, but they need to be improving at a faster clip,” said  Will Compernolle, a senior economist for FHN Financial in New York. “Even though core PCE came in less than expected — which is certainly unusual because there have been mostly upside surprises to inflation — the Fed will choose to ignore core PCE if people are still freaking out about CPI.”

Read: First Wall Street bank to call a U.S. recession now sees chance that inflation fails to decelerate

The separate consumer-price index report, released on June 10, included an annual headline rate that rose to 8.6% in May, an almost 41-year high, and was the third straight reading above 8%. The next CPI report won’t be due for two more weeks and until then “the burden of proof is on the inflation optimists that things are all going in the right direction,” Compernolle said via phone Thursday.

“Here we are at the end of June and this is May data,” the economist said. Though the monthly core PCE reading rose by 0.3% for the fourth month in a row — less than Wall Street’s 0.4% forecast — the momentum behind those numbers actually went up, he said. If stretched out to three digits, the rise in core PCE was 0.303% in February, 0.336% in March, 0.334% in April, and 0.348% May, based on calculations from the U.S. Bureau of Economic Analysis’ raw data — “nowhere near the monthly momentum needed to get prices close to the Fed’s target of 2%” on an annualized basis.

“For much of last year, there was a feeling that if you exclude this one thing or that, actually inflation is totally fine,” Compernolle said. “But in order to rein in Fed credibility, policy makers can’t show any sign of wavering in their will power on fighting inflation.”

As of late Thursday morning, all three major U.S. stock indexes remained down, with Dow industrials
DJIA,
-0.92%

off by almost 300 points. The S&P 500
SPX,
-0.88%

and Nasdaq Composite
COMP,
-1.23%

were down by 0.9% and 1.2%, respectively. Treasury yields were lower across the board, led by the belly of the curve, as buyers of government debt swooped in.

Fed funds futures traders continued to price in some chance of a rate cut next year on the view that policy makers will need to reverse its rate-hike campaign in an economic slowdown and/or will ultimately get inflation under control.

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