What Is PCE Inflation and How Does It Affect ETFs?

Ever wondered how rising prices at the grocery store or gas pump might impact your investment portfolio? And why does the Fed prefer the PCE report for its key measure of inflation? 

This article dives into how the PCE report's findings can influence stock and bond prices, as well as how certain exchange-traded funds might react to inflationary pressures. 

By understanding the connection between the PCE report, interest rates, capital markets and different types of ETFs, you can gain valuable insights into making informed investment decisions during periods of rising or falling inflation. 

What Is PCE Inflation?

PCE inflation refers to inflation measured by the Personal Consumption Expenditures (PCE) Price Index. The monthly PCE report is a key indicator used to track how much more expensive it's getting for households in the United States to buy the things they typically consume. The PCE report is maintained by the Bureau of Economic Analysis (BEA). 

Here's a deeper look at PCE inflation: 

• Focus on consumer spending: PCE inflation is based on the Personal Consumption Expenditures (PCE), which represents the total spending by U.S. households on goods and services. By tracking price changes in this basket of goods and services, the PCE reflects the inflation impacting everyday consumer purchases. 
• Federal Reserve preference: The Federal Reserve (Fed) closely monitors PCE inflation, particularly the core PCE index (excluding food and energy prices). This data is a major factor in their decisions regarding interest rates, which can influence the overall economy. 
• Comparison to CPI: Another common inflation measure is the Consumer Price Index (CPI). While both capture inflation, they have slight methodological differences. PCE inflation is generally considered more comprehensive as it takes into account a broader range of consumer spending, including out-of-pocket expenses and spending by non-profit institutions serving households. 

How the Fed Uses the PCE Report to Make Decisions

The Federal Reserve uses the PCE report as a key measure to inform their monetary policy decisions, especially regarding interest rates. The Federal Open Market Committee (FOMC) convenes eight times a year to discuss economic data and determine monetary policy adjustments. The PCE report is a major point of discussion during these meetings.  

Here's how the PCE report factors into the Fed’s decision-making process: 

• Focus on core PCE: The Fed prioritizes the core PCE index, which excludes food and energy prices. These categories can be more volatile due to external factors like weather or geopolitical events. By focusing on core PCE, the Fed gets a clearer picture of underlying inflation trends in the U.S. economy. 
• Inflation target: The Fed has a long-term inflation target of 2%. They aim to keep inflation at this level to maintain price stability and promote healthy economic growth. The PCE report helps them assess how close they are to this target and whether adjustments to monetary policy are necessary. 
• Impact on interest rates: If the core PCE inflation is running significantly higher than the 2% target, it signals overheating in the economy. To cool things down, the Fed might raise interest rates. Conversely, if core PCE inflation is well below 2%, it suggests sluggish economic activity. The Fed might then lower interest rates to stimulate borrowing and spending. 
• Other considerations: While the PCE report is crucial, the Fed doesn't base its decisions solely on this one indicator. They consider a broader range of data, including: 
• Labor market data: Employment figures, wage growth, and unemployment rate can provide insights into consumer spending and inflationary pressures. 
• Economic growth: Measures of Gross Domestic Product (GDP) growth help the Fed understand the overall health of the economy. 
• Financial markets: The Fed monitors financial markets to gauge investor sentiment and potential risks. 

How Changes in Interest Rates Affect Types of ETFs

Changes in interest rates can affect different types of ETFs in various ways, depending on the nature of the ETF's underlying assets and its investment strategy. Here's a breakdown of how interest rate changes can impact various types of ETFs: 

Fixed-Income ETFs 

Fixed-income ETFs, which invest in bonds, are particularly sensitive to changes in interest rates. Bond prices have an inverse relationship with interest rates—when interest rates rise, bond prices typically fall, and vice versa. 

• Duration sensitivity: The sensitivity of bond ETFs to interest rate changes is influenced by their duration. ETFs with longer durations are more sensitive to interest rate changes compared to those with shorter durations. For example, a long-term bond ETF would rise more in price than a short-term bond ETF when interest rates are falling. 
• Yield changes: Rising interest rates may lead to higher yields for newly issued bonds, which can benefit investors who reinvest coupon payments. However, existing bond holdings with lower yields may experience price declines. 

Growth Stock (Tech) ETFs

Growth stocks are typically priced based on the expectation of their future earnings potential. When interest rates rise, it increases the discount rate used to calculate the present value of those future earnings. This can lead to a decrease in the perceived value of growth stocks, causing their prices to fall in ETFs that hold them. 

This explains why growth stocks, especially those in the technology sector, declined dramatically in price in 2022, as inflation was rising and reached 40-year highs. Then, in 2023, as inflationary pressures began to ease, tech stocks jumped in price. 

Dividend ETFs

The impact of changes in interest rates on dividend ETFs depends on various factors, including the ETF's composition, sector exposure, interest rate sensitivity of underlying holdings, and investor sentiment.  

For example, real estate ETFs, which invest in real estate investment trusts (REITs) or real estate-related equities, are highly sensitive to changes in interest rates because REITs often use debt for financing. Thus, higher interest rates can increase their borrowing costs and affect their profitability. Conversely, lower or falling interest rates can be positive for REIT ETFs. 

Dividend-paying stocks also compete with fixed-income investments such as bonds for investor dollars. When interest rates rise, the yield on bonds and other fixed-income securities may become more attractive relative to dividend yields. As a result, investors may reallocate their investments away from dividend-paying stocks and into fixed-income securities, putting downward pressure on the prices of dividend ETFs.  

The opposite is true, so when interest rates are falling, dividend ETFs may become more attractive to investors and prices may rise. 

Commodity ETFs

Changes in interest rates are often correlated with inflation expectations, which, in turn, can affect commodity prices. Commodity ETFs, particularly those tracking inflation-sensitive commodities like gold or commodities with significant production costs like oil, may be influenced by interest rate changes. 

Changes in interest rates can also affect currency exchange rates, which can impact the prices of commodities traded in foreign currencies.  

Bottom Line on PCE, Interest Rates and ETFs

Changes in interest rates are driven by the Fed’s monetary policy decisions, which are influenced by various measures of inflation, particularly the PCE report. The impact of interest rate changes on ETFs varies depending on factors such as the ETF's underlying assets, investment strategy, sector exposure, and investor sentiment.  

Investors should consider these factors and conduct thorough research to understand how Fed policy and interest rate changes may affect their ETF investments.