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Posts tagged with: "PCEPILFE"

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From inflation targeting to average inflation targeting

The Fed’s new long-run monetary framework

Since 1996, it has been understood among Fed policymakers that the (undeclared) target for inflation was around 2%. In January 2012, Chairman Ben Bernanke made this implicit inflation target explicit and official, thereby aligning the Fed’s inflation target with that of all the major central banks. In this framework, when inflation has approached or exceeded the traditional 2% target, even temporarily as it did in 2018, the FOMC has responded by raising the baseline federal funds rate to combat rising prices.

In August 2020 at the online Jackson Hole conference, Chair Jay Powell announced a revision to the Fed’s long-run monetary policy framework by re-framing this goal as an average inflation target (AIT) of 2% over the long-run. With this new framework, the FOMC is communicating that it will tolerate inflation above its target for a period of time to offset periods when inflation was below its target. In other words, the FOMC is targeting average inflation of 2% in the long run.

So, what does past inflation data say about the feasibility of the new AIT? The FRED graph above plots two lines of data points over the past 25 years:

  • the FOMC’s preferred inflation measure, the core personal consumption expenditures index (core PCE), in blue and
  • the 2% target in red.

Given the recent asymmetric history of inflation, the concept of a symmetric target would represent a substantial change: Since the Great Recession of 2008-2009, there have been only two brief periods when the preferred inflation rate has exceeded the 2% target.

The FRED graph above also demonstrates how the new AIT guidance on inflation represents a substantial shift in thinking. In the past, the Federal Reserve has rarely tolerated rates above 2% and has raised interest rates whenever approaching the target. This new policy suggests that, if inflation can return to a range above 2%, the Federal Reserve will have to tolerate higher inflation than it has for much of the past 20 years—and tolerate it for significantly longer periods. Yet, given the pandemic, it could be challenging at this time to sustain average inflation above 2%.

How this graph was created: Search for and select “Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Index).” Select the time period January 1995 to the present month. Then select “Percent Change from a Year Ago” as the units. Next, use the “Add Line” tab to search for and select the same series. In the formula box type (a*2)/a, which results in a horizontal line of 2% for the target.

Suggested by Matthew Famiglietti and Carlos Garriga.

View on FRED, series used in this post: PCEPILFE

Measuring inflation trends

Why use different inflation measures for policy analysis?

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.

View on FRED, series used in this post: PCEPI, PCEPILFE, PCETRIM12M159SFRBDAL

The trouble with food and energy

There are many ways to measure inflation. One popular method used for monetary policy purposes is to look at the price index for personal consumption expenditures excluding food and energy. Why exclude food and energy? Aren’t those important items that matter a great deal to households? The reason is straightforward: These price categories are considered to be excessively volatile, and including them would make it more difficult for policymakers to pin down the inflation trend. The graph above makes this point visually by comparing the PCE inflation rates with and without food and energy.

Usually when you add items to an index, you reduce the volatility of that index. This same premise is at work when you add assets to an investment portfolio—i.e., when you diversify to reduce volatility. But this does not happen when the item you add is excessively volatile. And, again, food and energy are excessively volatile. Food is subject to large price variations due to external shocks, mostly on the supply side, such as weather. Energy is subject to shocks as well: supply shocks such as discoveries, wars, political risk, and infrastructure issues and demand shocks such as climate events. This happens with food and energy much more than it does for other items included in personal consumption expenditures.

How this graph was created: Search for “PCE.” Then go to the “Filter Series by Tags” box to the left and enter “price index.” Select the first two monthly series that appear and add them to the graph. Change the units for both series to “Percent Change From Year Ago.”

Suggested by Christian Zimmermann

View on FRED, series used in this post: PCEPI, PCEPILFE


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