OPCE Deflator 101: How This Inflation Measure Influences Stocks and Bonds
The OPCE deflator (official personal consumption expenditures) calculates inflation by measuring price fluctuations of goods/services which are typically purchased by the average consumer's household- Therefore, it serves as a financial thermometer, telling investors whether the economy is expanding or contracting.
While the Consumer Price Index (CPI) uses a standardised bundle of items to calculate inflation, the OPCE deflator allows for changes in the items that may be reflected in consumer spending patterns. For example, if beef prices rise, but consumers purchase chicken instead, the OPCE deflator captures this switch in purchases, whereas the CPI would not.
.How the OPCE Deflator Is Calculated
You can calculate OPCE Deflation by taking the total dollar amount of Personal Consumption Expenditures (PCE) and dividing it by the Real-PCE and multiplying that by 100. This way you can see how much the cost of goods and services has increased in price from what consumers are actually buying.
The Bureau of Economic Analysis collects data on PCE by separating it into different categories (Food & Beverages, Housing & Utilities, Healthcare, Transportation, Recreation and Other Services) and weighting them according to how much a typical Household spends on each of them. Typically the largest amount spent on a category is for Housing.
How the OPCE Deflator Moves Stock Markets
The performance of stock prices can change dramatically based on the U.S. Labor Department's Producer Price Index (OPCE) report , which helps investors make informed decisions about where the Fed will be taking interest rates. For example, when the OPCE comes in higher than expected, stocks generally drop in price as investors anticipate that the Fed will increase interest rates. Conversely, if the OPCE is lower than expected, it usually leads to a rally.
Technology sector (or Tech) stocks generally see larger movements than other sectors when the OPCE has a significant change. Technology companies such as Apple and Microsoft typically trade at higher multiples than other sectors, based on projected future earnings. If the OPCE shows a higher inflation rate, and subsequently the Fed raises the interest rate, the net present value of those future earnings will decrease. Therefore, in 2022 alone, technology stocks lost more than 30% in value because of rising OPCE and aggressively increasing interest rates by the Fed.
OPCE Deflator and Bond Markets
When inflation is expected to rise according to the OPCE, interest rates (yields) increase because investors need a higher return to offset the risk posed by future inflation. Bond prices are inversely related to interest rates (Yields); therefore, when interest rates rise, existing bonds decrease in value, and one of the benchmarks used to set interest rates for other loans is the 10-Year Treasury yield, which usually rises between 10-20 basis points on releases of good OPCE news.
Example: If you lend your friend $100 at 3% interest for one year and the overall cost of living (or inflation) increases by 5%, then you've actually lost money because your net income would be negative; therefore, you would require a higher interest rate on the loan to receive a positive return. This is similar to the way in which bond investors respond to increasing rates of inflation from the OPCE.
OPCE Deflator and Federal Reserve Policy
When the OPCE consistently stays above the Fed's 2% annual target, it is likely that the Fed will raise rates to slow down borrowing and spending, therefore lowering demand for goods, thereby lowering prices. On the other hand, if the OPCE falls below the target rate, it is likely the Fed will consider cutting rates to stimulate economic growth.
For example, the OPCE was at 5.3% at the start of 2023, which influenced the Fed's position of aggressively raising rates. The OPCE later declined to 2.6% by December 2023, providing the Fed with the opportunity to pause rate increases or consider lowering rates in the future. This shift greatly impacted investors.
Key Takeaways for Investors
Global Considerations are Important: Understanding the relationship between the OPCE, US inflation, and inflation in foreign countries provides an important advantage to those investing abroad and managing foreign currency risks.
Successful investors will utilize the OPCE Deflator as a guiding tool or compass rather than a crystal ball, enabling them to identify potential Fed actions and market consequences, resulting in better-positioned portfolios. By mastering this indicator, you will benefit from significant advantages when navigating the impact of inflation on your investments.
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