Tag: inflation expectations

PCE Inflation: Still Too High

Posted on by Paul Gomme

By Paul Gomme and Peter Rupert

About the only good thing that can be said about the incoming PCE inflation data: It could have been worse. At an annual rate, the month-over-month overall PCE inflation rate popped up to 3.22% in August from 1.97% in July; the corresponding core PCE inflation rate slipped from 2.86% to 2.76%. The annual (year-over-year) PCE inflation rate rose from 2.60% to 2.74%; core, from 2.85% to 2.91%. Finally, our measure of trend PCE inflation rose to 2.72% from 2.46%; trend core PCE inflation fell slightly to 2.84% from 2.88%.

And exactly what is so troubling in terms of the real side of the economy? Granted, there have recently been some very low employment numbers. Yet, a broader look at the labor market doesn’t add up to ringing the alarm bell and lower rates. In terms of job openings, outside of the pandemic, the rate of job openings is pretty much the highest it has ever been. There has been no obvious change in the rate of layoffs. The unemployment rate remains quite low by historical standards. Real gross domestic product was recently revised up, from 3.3% to 3.8%. Using monthly data on non-farm payroll
employment, industrial production, real personal income excluding transfer payments,
and real manufacturing and trade sales, the probability of being in a recession (here is the Piger website) is 1.0%.

Policy Outlook

In the FOMC’s recent announcement reducing its policy rate by 25 basis points, the committee expressed its opinion that the balance of risks has shifted towards unemployment…and away from inflation. We stand by our earlier opinion that job number 1 for the Fed is low and stable inflation; good real-side outcomes will ultimately result from executing on the inflation front. The risk to the policy outlook is that 3% inflation is the new de facto target, up from the stated 2% target. Already, short-term inflation expectations have risen. Experience from the 1970s and 1980s tells us that it is economically painful to reduce expected inflation. Responsible policy would see the Fed bringing inflation back down to its 2% target, with fiscal policy addressing the jobs situation.

July PCE inflation

Posted on by peter.c.rupert

by paul gomme and peter rupert

The BEA announced that inflation as measured by the annualized month-over-month change in the Personal Consumption Expenditure (PCE) price index fell from 3.49% (June) to 2.40% (July) on an annualized basis. Our corresponding measure of trend inflation also fell, from 2.63% to 2.55%. However, the annual (year-over-year) measure rose slightly, from 2.56% to 2.60%.

As is well known, the FOMC concentrates more on core PCE inflation (that is, excluding the “volatile” food and energy components). Core inflation rose across the three measures we regularly report. The annualized month-over-month rate rose from 3.20% to 3.33%; the year-over-year from 2.77% to 2.88%; and our measure of trend from 2.80% to 2.98%.

The PCE inflation results were foreshadowed by the earlier CPI release.

Earlier this week, the BEA also released its second estimate for quarter 2 Gross Domestic Product. In brief, output growth was revised up from 3% to 3.3%.

Policy Outlook

We’ll organize our discussion of the policy outlook around the Taylor rule which prescribes setting the FOMC’s policy rate, the Federal funds rate, based on: (1) the “neutral” Fed funds rate, given by the sum of the real interest rate and the inflation rate; (2) how much the inflation rate exceeds target; and (3) some measure of real activity like the output gap (potential output less actual) or the unemployment rate gap (the actual unemployment rate less its natural rate). (For those wishing to play around with different scenarios, the Atlanta Fed has a web page for that.)

While in theory each of these components is well defined, in practice they are not. Start with inflation. Measuring inflation seems pretty straightforward, particularly since the FOMC has stated its preference for core PCE inflation. At what horizon should inflation be measured? As we’ve harped on in the past, the month-over-month rate is too volatile while the year-over-year rate takes a long time to capture changes in trend. Suppose that the FOMC uses something conceptually similar to our measure of trend inflation. We still face the problem of accounting for transitory phenomena like Trump’s tariffs. Some folks (including some members of the FOMC) argue that these tariffs have pushed up the price level without changing the underlying trend. As a result, measured inflation will be higher, but this does not reflect a change in trend. As always, the devil is in the details: How much of current inflation is due to these transitory factors?

Next, measuring gaps is hard and subject to measurement error. The output gap requires knowing potential output which is the level of aggregate output that the economy could produce with current resources (labor force, capital, etc.) used at typical intensities. Similarly, the unemployment rate gap depends on the natural rate of unemployment: the rate that would prevail in the long run absent shocks. Both potential output and the natural rate of unemployment need to be estimated and so are subject to uncertainty. Further, the current environment is sending mixed signals regarding the real side of the economy. Output growth for the second quarter is humming along quite nicely, but this growth comes on the heels of a disappointing first quarter. The revised job creation data suggest an anemic labor market, but the unemployment rate is still low.

Finally, the neutral Fed funds rate suffers not only from the inflation issues discussed above, but also problems in measuring the real interest rate. The problem for those arguing that the current Fed funds rate is too restrictive — meaning that it’s above its neutral rate — is that we don’t really know that neutral rate.

Those advocating cuts to the Fed funds rate argue some combination of: (1) monetary policy is too tight: the Fed funds rate is well above its neutral level; (2) while inflation is above target, this is due to transitory factors like Trump’s tariffs; and (3) the real side of the economy is weak as evidenced by the job creation numbers.

The case for no change is built on: inflation is too high (and increasing of late) and therefore a restrictive monetary policy is appropriate, and there are mixed signals from the real side of the economy.

The political pressure being applied to the FOMC adds yet another complication. To grasp the nature of this problem, keep in mind that the Fed controls one interest rate: the Federal funds rate which is an overnight rate relevant to banks. The following discussion also makes use of the Fisher equation which states that the nominal interest rate is the sum of the real interest rate and expected inflation. Given that inflation is above target, the risk of cutting the Fed funds rate is that market participants may view the Fed as caving to political pressures to lower interest rates. In turn, market participants may well question the Fed’s credibility and its commitment to low, stable inflation. As a result we would expect a rise in inflation expectations. Then, via the Fisher equation, such an increase in expected inflation will lead to a rise in market interest rates in order to compensate investors for the higher inflation they anticipate. Paradoxically, the political pressures on the Fed make it important for the Fed to keep the current level of the Fed funds rate in order to maintain the Fed’s political independence and credibility. No one wants to be painted as the second coming of Arthur Burns. Here is a fascinating podcast describing how Arthur Burns capitulated to Richard Nixon, bringing about the worst inflationary episodes in recent U.S. history.

February cpi cools

Posted on by peter.c.rupert

The BLS announced that the CPI rose 2.62% on an annualized basis, the lowest reading since August, 2024. Year over year inflation came in at 2.81%. Our preferred trend measure of inflation was 3.62%. The report offers some good news given the CPI spike in January. The biggest decline came from energy commodities (gasoline and fuel oil), down 10.1% on an annualized basis, down 3.17% year over year; however, our trend measure rose 8.53% due to outsized increases in January (13.8%) and February (17.9%). Energy prices are extremely volatile as can be seen in the magnitude of the scale in the energy graph.

Given the volatility mentioned above, policy makers often remove food (including the price of eggs) and energy from the index, namely, core CPI. The monthly core number fell from 5.49% to 2.75% on an annualized basis, and from 3.29% to 3.14% year over year. Our trend measure fell from 5.85% to 3.49%.

While there is a small sigh of relief given January’s spike in inflation, the core numbers are still solidly above the Fed’s 2% target. Moreover, these numbers from February do not reflect the recent tariff measures put in place and may take many months before we see any price effects. Looking at future inflation expectations, however, reveals a marked increase in prices. The breakeven inflation rate represents a measure of expected inflation derived from 5-Year Treasury Constant Maturity Securities and 5-Year Treasury Inflation-Indexed Constant Maturity Securities. The latest value implies what market participants expect inflation to be in the next 5 years, on average.

Meeting next week, the Fed will almost surely stay the course with no change in rates as they wait to see how current policies play out over the next few months.

PCE Inflation and Revised GDP for Quarter 1

Posted on by Paul Gomme

The BEA announced May PCE (Personal Consumption Expenditure) data that reinforces the earlier CPI (Consumer Price Index) report: Inflation continues to creep down. Annualizing the month-over-month change in the PCE, inflation for May was 1.55%, well below the Fed’s 2% target. As we have commented before, these month-to-month changes contain a lot of noise and our preferred measure is the annualized 3 month change. By this measure, inflation for May was 2.45% – somewhat higher than the 2.2% reported earlier for the CPI. The headline year-over-year PCE inflation rate for May was 3.85%. As we have emphasized in previous posts, this year-over-year measure of inflation is slow to respond to changes in trend which means it will take some time for the year-over-year inflation rates to reflect the lower inflation rates that have come in over recent months.

Less rosy is the inflation picture coming from core PCE (that is, excluding food and energy). While the month-over-month rate was down in May – from 4.65% to 3.84% – the year-over-year and 3 month measures fell by roughly 0.1 percentage points. Presumably, the reason to look at core PCE inflation is that it provides a better gauge of underlying trend inflation than non-core PCE measures. But for our money, the 3 month PCE inflation rate does a good job capturing developments in trend inflation.

For June, expected inflation is now running below 2% at all horizons. Collectively, the results for CPI, PCE and expected inflation suggest that the tightening of monetary policy over the past year-and-a-half has brought down both actual and expected inflation. In this context, the Fed’s decision in June to pause its tightening of monetary policy seems like a good one, especially if one takes into account the well-known long and variable lags of the effects of monetary policy on the economy.

Finally, while we at Economic Snapshot usually do not comment on GDP (Gross Domestic Product) revisions, we are making an exception for the data released on Thursday by the BEA. The output revision was a very large 0.7 percentage points, from 1.27% to 2.00%. This upward revision of output can be attributed to upward revisions in consumption and exports, and a downward revision of imports (which has a positive effect on output since imports are subtracted from output). These effects were partially offset by small revisions in investment and government spending.

Second
Revision		Third
Revision		Difference
Output1.272.00+0.73
Consumption2.652.93+0.28
Investment-2.10-2.17-0.07
Government0.880.85-0.03
Exports0.661.00+0.33
Imports-0.75-0.37+0.38
GDP growth for the first quarter of 2023, and contributions to GDP growth by its major components.

The increase in real GDP was widespread according to the state GDP estimates. Real GDP increased in all 50 states in Q1. The largest increase came in North Dakota, 12.4% at annual rate and the lowest in Rhode Island and Alabama at 0.1%. Personal income increased in all but two states, Indiana (-1.0%) and Massachusetts (-0.9%).

March CPI, PPI and inflation expectations

Posted on by Paul Gomme

By Paul Gomme and Peter Rupert

The March CPI (Consumer Price Index) brought decidedly mixed news. Year-over-year, CPI inflation fell from 6% in February to 5% in March. Indeed, the year-over-year inflation rate has trended down since mid-2022. However, as we have pointed out in earlier posts, year-over-year measures of inflation are slow to reflect recent changes in trend since they are 12 month averages of past monthly inflation rates. The good news is that monthly (annualized) inflation is down from 4.5% (February) to 0.6% (March), well below the Fed’s 2% inflation target. A glance at the chart below will remind regular readers that monthly inflation rates exhibit considerable variability. Our preferred measure is the 3-month average of monthly inflation rates. This measure declined more modestly, from 4.1% to 3.8%. More importantly, the 3-month average inflation rate is still well above the Fed’s 2% target.

The news is decidedly worse when looking at core CPI inflation (that is, excluding the volatile food and energy components). On a year-over-year basis, core CPI inflation rose from 5.5% in February to 5.6% in March. On the other hand, the monthly core CPI inflation rate fell from 5.6% to 4.7%. Again, we prefer to look at the 3 month average to gauge the direction of trend inflation. The 3 month average of core CPI inflation fell slightly, from 5.2% to 5.1%. More troubling is that these measures are all well above the Fed’s 2% inflation target.

The producer price index (PPI) was released today that offered up a little more good news. The PPI fell 0.5% in March. Moreover, as noted by the BLS, “two-thirds of the decline in the index for final demand can be attributed to a 1.0-percent decrease in prices for final demand goods. The index for final demand services moved down 0.3 percent.”

Finally, short term inflation expectations have risen: For the one year horizon, from 2.1% in March to 2.6% in April; at the two year horizon, from 2.2% to 2.4%. These developments are, presumably, unwelcome by policymakers who are worried about higher inflation expectations becoming entrenched. Fortunately, the five year expected inflation rate fell from 2.2% to 2.1% while 10 year expectations dropped from 2.3% to 2.1%.

Overall, as mentioned at the outset, the news is mixed. Yes, the CPI is down. But, the year over year core CPI is up. The main reason for the difference between the CPI and CORE CPI is that energy prices fell: gasoline, down 17.4%, and fuel oil, down 14.2%. Given the highly volatile nature of food and energy it is useful to pay attention to the core measure.