Congress has instructed the Federal Reserve to pursue monetary policies that promote maximum employment and price stability. The Federal Open Market Committee (FOMC) has determined that “inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures [PCE], is most consistent over the longer run with the Federal Reserve’s statutory mandate” for price stability. As of March 2018, the year-over-year percent change in the PCE was 2.01 percent, or just 1 basis point above the FOMC’s 2 percent target. However, inflation was substantially lower over much of the past year—as low as 1.40 percent in July 2017—and economists were uncertain whether the low readings reflected temporary factors that would soon dissipate or an underlying inflation rate that was below the level consistent with price stability.
Because the inflation rate measured by the headline PCE tends to be volatile from month to month, many observers monitor other measures, such as the PCE excluding food and energy prices (“core PCE”), to gauge underlying inflation trends. The near-term growth in core PCE is among the economic variables that the FOMC includes in its quarterly Summary of Economic Projections. As of March 2018, the year-over-year growth in core PCE was 1.88 percent. Some critics argue that this measure of inflation is “rotten,” however, because it arbitrarily excludes particular categories of goods whose prices affect the cost of living.
An alternative, and somewhat less arbitrary, measure of underlying inflation trends is based on the mean of changes in the prices of the individual goods and services that make up the price index after dropping items with exceptionally large or exceptionally small price changes in a given month. For example, the Federal Reserve Bank of Dallas calculates a trimmed mean PCE inflation measure designed to hew closely to the trend in overall PCE inflation. By omitting price changes for goods and services having the largest or smallest price movements in a given month, extreme values have less impact on the measured inflation rate, which arguably is a better measure of underlying inflation trends than the traditional core measure.
The chart plots the headline, core, and Dallas Fed trimmed mean PCE inflation rates, measured as percent changes over the past 12 months, for the past year. Whereas the headline PCE inflation rate increased from 1.73 percent in February to 2.01 percent in March, and the core rate rose from 1.57 percent to 1.88 percent, the trimmed mean rose only from 1.71 percent to 1.77 percent. Hence, in contrast with the headline and core measures, the trimmed mean indicates little, if any, change in underlying inflation pressures in recent months, suggesting that low inflation readings might be more reflective of underlying trends than temporary special factors.
How this graph was created: Search for “PCE,” check the three series, and click on “Add to Graph.” From the “Edit Graph” menu, change the units to “Percent Change from Year Ago.” Change the frequency to “Monthly” and the starting date to “2017-03-01.”
Suggested by David Wheelock.