Inflation is the backbone of modern central banking but it has generally been an afterthought in the US economics conversation.

Growth has been all over the place in the US this year, from a 2.1% contraction in Q1 to a 3.5% jump in Thursday’s report. But even growth has been overshadowed by the never-ending debate about the quality of the US employment market.

The Fed finally changed the channel on Wednesday by saying the “underutilization of labor resources is gradually
diminishing” after months of worrying about significant slack. But as Yellen & Co begin to shut the door on one debate, they’re fuelling another.

The FOMC also noted that “market-based measures of inflation compensation have declined somewhat.” It’s an ode to the fall in breakeven rates, which measure the difference between TIPS and Treasury yields. Breakevens imply just 1.53% inflation over the next 5 years and that has the Fed concerned.

The market is tuning in as well. The GDP report showed inflation running at just 1.4% in Q3, short of the 1.5% consensus. That’s the same pace of inflation expected in the PCE deflator in September.

PCE deflator year over year

PCE deflator year over year

With inflation so low, and the falls in commodity prices likely to add further downward pressure, the question is: Why does the Fed need to hike at all?

The other element to watch in the PCE report is personal spending. Consumption was soft in the GDP report and if spending misses the +0.1% m/m consensus in September, the market could get worried. It will be difficult initially to separate the difference between soft consumer spending and lower gasoline spending but, overall, the market would rather see gasoline savings being spent elsewhere.

If the number surprises to the upside, it could be a result of spending on the iPhone released in September but that didn’t show up in the official retail sales data.