Fed’s favorite inflation index indicates rising prices, rates

With the labor market improving to the point that the unemployment rate is below 5 percent, close to economists’ definition of full employment, the Fed’s attention is likely to pivot in 2017 to the other side of it dual mandate — inflation. 

The typical well-informed, non-economist probably finds the discussion of inflation tough to follow, with all sorts of acronyms and dueling metrics thrown around to describe the price situation. 

{mosads}In reality, there are many different ways to slice and dice the price data, but the details need not be so dizzying.

The most well-known price measure is the venerable consumer price index (CPI). This gauge measures the changes in cost over time of a fixed basket of goods and services that households consume. 

A critical distinction is that it is limited to out-of-pocket expenses. In contrast, the Fed has chosen to focus in recent years on the personal consumption expenditure (PCE) deflator, which is a less-known but more comprehensive price measure. 

It puts prices on everything that the government statistics agencies consider “consumer spending,” including plenty of items that are paid for by other entities (health care paid for by insurance companies or by government programs such as Medicare and Medicaid, for example), as well as a number of items for which explicit prices do not even exist (the cost of financial services that banks extract by maintaining a gap between savings and borrowing rates, for example). 

The Fed prefers the PCE deflator to CPI because it covers a broader range of goods and services, and because the importance of the components constantly adjusts to shifting spending patterns. Conversely, CPI reflects a fixed basket of items, with weights adjusting only once a year.

There are two other manipulations that the Fed and economists like to perform on the inflation data. First, most officials tend to concentrate on the 12-month, or year-over-year, change in inflation rather than the monthly swings, which can be distractingly volatile. 

Second, in an effort to filter out the noisiest parts of the data, like gasoline prices, economists have various formulas for excluding outliers to get a better sense of the underlying inflation picture. 

The most common filter is the so-called “core” inflation, which excludes food and energy costs that were thought to be among the most volatile categories when the “core” formulation was created in the 1970s. Today, energy prices remain extremely volatile, while food prices have smoothed significantly.

More recently, Fed economists have begun to focus on a “trimmed mean” calculation, which simply eliminates the highest and lowest categories and recalculates the inflation rates based on the middle group of price changes. 

For example, the Dallas Fed puts out a “trimmed mean” PCE figure that is calculated based on the middle 50 percent of line items. 

The idea here is that there is no need to arbitrarily define food and energy prices as the most volatile when it is easy enough to run the numbers to figure out what prices are actually the noisiest before removing them from the calculation.

With that as explanation, what did we learn from the release of the PCE deflator data for December? First, headline inflation is rising on a year-over-year basis. Energy prices were falling sharply a year ago, but are now rising on a seasonally-adjusted basis.

As a result, the 12-month change in the overall PCE deflator, which tends to swing with the massive fluctuations of energy prices, has accelerated from less than 1 percent as recently as July to 1.6 percent in December.

This is still somewhat below the Fed’s 2 percent inflation target, but it’s the highest reading since 2014. It looks like overall inflation, as measured by the PCE deflator, could hit 2 percent before mid-year. 

Meanwhile, the “core” PCE deflator, which tends to be more stable by design, on a year-over-year basis held steady in December at 1.7 percent.

The Dallas Fed “trimmed mean” PCE indicator accelerated on a 12-month basis to 1.85 percent, still closer to 2 percent and the highest reading for that index since 2012. 

In short, while the details vary, the bottom line for all three of these measures is roughly the same — inflation lies below the Fed’s 2 percent target, though not by much, and it’s creeping higher. 

As the various inflation measures that the Fed tracks near 2 percent, the ultra-low interest rate policy that the Fed has continued to pursue since the crisis will seem increasingly anachronistic.

Stephen Stanley is the chief economist for Amherst Pierpont, a broker-dealer that provides institutional and mid-market clients access to fixed income products. 

The views of contributors are their own and not the views of The Hill.