What is the impact of the price of oil on an inflation measure that excludes the price of oil? A look at the Core PCE

A recent econometric analysis covering the volatile period from late 2020 to late 2025 reveals a striking paradox in how we measure inflation. Utilizing WarpPLS () to conduct a nonlinear robust path analysis, we found that the association between Brent Crude oil prices and the Core Personal Consumption Expenditures (PCE) price index stands at a remarkable 0.78. Perhaps most significantly, the WarpPLS Nonlinear Bivariate Causality Direction Ratio (NLBCDR) suggests a causal link, indicating that fluctuations in oil prices are likely a primary driver of the Core PCE’s movement. This challenges the conventional wisdom of inflation tracking, as it suggests that oil prices account for approximately 60 percent of the variance in a metric specifically designed to exclude energy costs.

The nature of this relationship is distinctly nonlinear, characterized by a strong correlation that eventually hits a ceiling. Within the price range of approximately $54 to $105 per barrel, the linear association (correlation) between Brent Crude and Core PCE is a high 0.91. In this range, a $1 increase in the price of oil is associated with a 0.08 increase in Core PCE inflation. However, once oil prices exceed the $105 threshold, the relationship turns flat, suggesting a diminishing marginal impact on core inflationary pressures at very high oil price levels. This "warped" relationship explains why core inflation can feel so tethered to the gas pump during moderate price climbs, yet appears decoupled during historically high oil spikes.

These findings necessitate a fundamental re-thinking of the Core PCE measure as a tool for monetary policy. If "Core" inflation is intended to strip out volatile elements to reveal the underlying price trend, its 60 percent dependency on oil—one of the very elements it seeks to exclude—suggests that energy costs are far more "sticky" and systemic than previously assumed. For investors and policymakers, this means that Core PCE may not be a very reliable measure of domestic demand, but rather a lagging reflection of energy-driven supply chain costs. Understanding this nonlinear dependency is crucial for anticipating Fed shifts in an era of energy transition.

How inflation widens the wealth gap

The figure below shows the pay of two individuals, L (lower pay) and H (higher pay). Their pay starts respectively at $50K and $100K in year 1, and is then adjusted by the official rate of inflation, until year 20. We assume two rates of inflation, 0.5% and 5%, which leads to the values on the left and right tables. We also assume that individual L has no savings (i.e., earns only enough to live paycheck by paycheck), and that individual H saves the difference and invests it in a financial instrument that pays the official rate of inflation (e.g., a specialized money market fund).

Looking at these gaps, one could conclude that the rate of inflation does not make any difference in either the pay or wealth gap between individuals L and H. H’s pay is twice L’s pay regardless of inflation rate. And the amount saved by H in year 20 at 5% inflation is worth the same as the amount saved in the same year at 0.5% inflation, in terms of purchasing power. These conclusions may make sense, until we consider two facts that are illustrated in the figure below from FRED, which shows the rate of inflation for IT products and services.

The first fact we should consider is that the rate of inflation is not the same for all items. We can see that, for IT products and services, the rate of inflation is negative most of the time in the graph. Given this, individual H can buy significantly more IT items in year 20 at 5% inflation, and certainly way more than individual L at 0.5% inflation. The second fact we should consider is that the rate of inflation becomes very negative near or during recessions (see left part of the graph, near 2008). This places individual H at an advantage at 5% inflation, because as prices go down, H’s higher absolute savings will buy more.

As you can see, the wealth gap widens more at higher inflation rates. It is noteworthy that more and more of people’s expenses, even large ones, are related to IT products and services. But inflation for these has been typically negative in modern times. So, someone whose pay is adjusted for inflation at a higher rate will be able to buy more and more of these products and services as time goes by. Moreover, that person will also be in a better position to take advantage of economic downturns that lead to sharp downward corrections in prices, which happen regularly. The video linked below provides a brief discussion on this a few other related issues.

A simulation-based valuation of Facebook (FB): October 2021

Summary

- FB is the largest online social network in the world (). Given its enormous reach, with 2.5 billion monthly active users, it is a much sought-after conveyor of ads.

- In this post we provide a simulation-based (sim-based) valuation () of FB.

- Our sim-based analysis suggests the following fair values – stock price: $417.67, and price-to-earnings ratio: 32.61. At the time of this writing, FB trades at $324, so it appears to be undervalued, with a potential upside of about 29%.

Facebook (FB)

FB is the largest online social network in the world (). Given its enormous reach, with 2.5 billion monthly active users, it is a much sought-after conveyor of ads. As such, most of its sales are from ads placed within its “ecosystem”: the Facebook app, Instagram, Messenger, WhatsApp, and various app-specific features. Ad sales represents more than 90% of FB’s total sales; with 50% being in the U.S. and Canada, and 25% in Europe.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of FB.

At the time of this writing the company had a profit margin of 37% and a price-to-earnings (PE) ratio of 25.3. The expected growth in earnings for the next 5 years is 28.6%, which is what we will use for the sim-based earnings growth rate. The table below summarizes our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $417.67, and PE ratio: 32.61. At the time of this writing, FB trades at $324, so it appears to be undervalued, with a potential upside of about 29%.

Final thoughts

Is inflation likely to become a problem for FB? We often hear from experts on business media outlets that inflation has a much more pernicious effect on growth stocks than value stocks. We looked into this issue in another post (). Our analyses suggested that growth stocks may do better under relatively high inflation (around 5%) than value stocks.

Moreover, FB’s leadership position would allow it to raise its prices to make up for inflation. Many other firms would not be in the same position, as the leaders in any industry are by definition only a few in number. This could lead to PE expansion, which would make our estimate conservative.

Disclosure

The author owns FB shares at the time of this writing.

Would growth underperform value at 5% inflation: A simulation-based approach

Summary

- We often hear from experts on business media outlets that inflation has a much more pernicious effect on growth stocks than value stocks.

- In this post we provide a simulation-based (sim-based) assessment () of this assumption.

- Our results suggest that growth stocks may do better under relatively high inflation than value stocks.

The nonlinear relationship between the PE ratio and earnings growth

In a previous post () we have shown that there is a nonlinear relationship between the price/earnings (PE) and the price/earnings to growth (PEG) ratios, which are widely used measures of company valuation. The PE divided by the PEG yields the expected growth in earnings, usually for the following 5 years.

Value stock

For the purposes of our discussion, we will consider a fictitious “value” company with a stock price of $100 and expected earnings growth of 10% (real growth of 5%). The PE ratio is 11.89 (see: ), which is considered fair assuming that there is no inflation. (An equivalent assumption, with slightly different simulation parameters, would be that the rate of inflation is covered by the company’s dividend.)

The table below summarizes our sim-based estimation of the fair value of this value company at 5% inflation. As you can see, it is $77.76. The reduction (from $100) accounts for the yearly loss of 5% in real terms.

Growth stock

We will also consider a fictitious “growth” company with a stock price of also $100 and expected earnings growth of 75% (real growth of 70%). The PE ratio is 260.47, which is considered fair, again, assuming that there is no inflation (see: ).

The table below summarizes our sim-based estimation of the fair value of this value company at 5% inflation. As you can see, it is $80.58. Analogously to what happened with the value company, here the reduction (from $100) accounts for the yearly loss of 5% in real terms.

Comparative performance

The table below summarizes a comparison of the two sim-based estimations for the value and growth stocks. Note that in neither case we assume that the company can pass on the inflation to its customers. As you can see, the growth stock does better under relatively high inflation than the value stock.

What we often hear from experts on business media outlets is that inflation has a much more dramatic negative effect on growth stocks than value stocks. That is not what our simulation suggests.

Final thoughts

Both value and growth stocks should be affected by the expectation of future inflation. If that expectation proves to be incorrect, then an upward adjustment should ensue.

Generally speaking, inflation should be particularly problematic for companies that sell tangible items via influential retailers, because usually the companies have to wait for the items to be sold to get paid.

The above scenario is normally seen in the manufacturing sector, which is usually where value companies are.

If you go back to the sim-based results on the two similar tables, you will notice that at year 10 both value and growth stocks approximately triple in nominal terms – this is what we assume in our algorithms to set our fair values; going “backwards”, so to speak.

But if you look at years 11 and 12, growth significantly outperforms value.

Reflation or inflation? A look at 12-month commodity trends in January 2021

Summary

- The term “reflation” is used in this post to refer to an increase in certain commodity prices due to the expectation of increased economic activity.

- The term “inflation” refers to an increase in certain commodity prices due to currency devaluation.

- When we look at the past 12-month period, copper has been increasingly outperforming silver, and silver outperforming gold.

- The patterns above suggest reflation, which is generally bullish for equities going forward.

Reflation versus inflation

The term “reflation” is used in this post to refer to an increase in certain commodity prices due to the expectation of increased economic activity. The term “inflation” refers to an increase in certain commodity prices due to currency devaluation. Generally speaking, reflation would be bullish for equities, and inflation would not.

12-month commodity trends: Copper, silver, and gold

A sign of reflation would be a 12-month trend characterized by copper outperforming silver, and silver outperforming gold – in terms of price. Inflation, on the other hand, would be characterized by gold outperforming silver, and silver outperforming copper.

The figure below shows the past 12-month performances, in terms of price increases, for the following commodity funds: SPDR Gold Shares (GLD), iShares Silver Trust (SLV), and United States Copper Index Fund, LP (CPER). The performances are measured by percentage increases in prices for the past 12 months, 6 months, and 3 months.

As you can see, the trend for the past 12 months has been one of copper increasingly outperforming silver, and silver outperforming gold. Silver has actually done better than copper when we consider the entire 12-month period, but copper has been significantly outperforming silver more recently – in the past 6 and 3 months.

The patterns above suggest reflation, which is generally bullish for equities going forward. These patterns are particularly bullish for “banks and tanks” equities, and also for commodities in general – more so for commodities that have an industrial use.