By Paul Gomme and Peter Rupert
The BEA announced a downward revision from 2.7% to 2.6% in the third and final estimate of Q4 GDP. The revision primarily reflected downward revisions to exports and consumer spending. The final estimate for 2022Q4 GDP did not change the overall stance of the US economy.
Several sources picked up on the fact that the PCE price index, the primary inflation index cited by the Fed, fell. CNBC reported: “On a 12-month basis, core PCE increased 4.6%, a slight deceleration from the level in January.” The New York Times remarked,
The measure of inflation most closely watched by the Federal Reserve slowed substantially in February, an encouraging sign for policymakers as they consider whether to raise interest rates further to slow the economy and bring price increases under control.
The Personal Consumption Expenditures Index cooled to 5 percent on an annual basis in February, down from 5.3 percent in January and slightly lower than economists in a Bloomberg survey had forecast. It was the lowest reading for the measure since September 2021.
NYT, March 31, 2023
However, as we remarked in an earlier post, measured inflation is sensitive to the time horizon over which it is computed. Annualized month-to-month inflation rates are quite volatile; year-over-year inflation is much smoother, but is slow to reflect changes in trend inflation. And it’s trend inflation that policymakers, among others, are concerned about. Yet, identifying trend inflation is difficult. One approach is to average monthly inflation rates over a few months. In the figure below, we include the 3-month average of monthly inflation rates which is our attempt to balance the desire to smooth monthly inflation rates while capturing changes in trend in a timely fashion.
The Fed tends to focus on so-called core PCE inflation for which the volatile food and energy components are removed. Presumably, the reason for looking at core PCE inflation is that it gives a better read on trend inflation. To be sure, core PCE inflation is less volatile, as shown in the chart below. Nonetheless, this measure continues to exhibit large fluctuations when measured on a monthly basis. And, it should not be surprising that the annual (year-over-year) inflation rate is smoother, but slow to reflect changes in trend inflation. Again, we include the 3-month average of monthly inflation rates.
One way to think about the problem of extracting a measure of trend inflation from the data is that observed inflation is composed of trend inflation and an ‘error’ which reflects issues in measuring trend inflation. In the jargon of the profession, we face a signal extraction problem: we are trying to extract the signal (trend inflation) from noisy data (measured inflation). Averaging monthly inflation rates over some horizon (for example, over 3 months, as above) can be thought of as canceling out the positive and negative error terms in this signal extraction problem. (Again, using some jargon, ideally the errors are uncorrelated over time, or independently and identically distributed.)
Finally, what are the policy implications of the latest PCE price index numbers? As mentioned above, some commentators have noted that PCE inflation was down in February relative to January. True enough when looking at either the monthly inflation rate, or the year-over-year inflation rate. However, the 3 month average inflation rate is up. It is hard to make a strong case that there has been a change in trend inflation. In any event, all of the gauges of inflation presented above continue to run well above the Fed’s stated 2% target.
