Not All Inflation Is Created EqualDanielle DiMartino
- In theory if you net out the volatility typically associated with items such as milk and gasoline prices, you get a more reliable gauge of price movements.
- “The CPI is based on a survey of what households are buying; the PCE is based on surveys of what businesses are selling.”
- The government’s de facto ‘price fixing’ of medical care costs has kept a lid on PCE relative to CPI.
- Come the next slowdown, the Fed can hold interest rates lower for even longer than ever before with a higher target based on a still-arbitrary measure
Can something be arbitrary and at the same time deeply damaging? Pursuing a strategy based on personal preference rather than reason can indeed inflict deep wounds if carried on for too long. Such is the case with the Federal Reserve’s preferred inflation metric, the “core PCE.”
Technically speaking, core personal consumption expenditures (PCE) exclude food and energy prices to arrive at the underlying inflation paid by households for goods and services. In theory if you net out the volatility typically associated with items such as milk and gasoline prices, you get a more reliable gauge of price movements.
Economists tell themselves that such reasoning is sound but try that same logic with the average consumer with a straight face. Because it’s their paycheck that will be decimated. In the space of five years, every dollar of their pay will be reduced to 90 cents. How is this in the public interest?!
Clearly Alan Greenspan was right when he said that the ideal inflation rate for households was zero.
As to the ‘arbitrary,’ ever since the Fed adopted its core PCE inflation target of 2%, it has stuck to it like super glue. The rationalization behind the target, however, has been shattered in recent years, a victim of prima facie evidence that outs the weakness of the core PCE compared to other measures of inflation.
Starting with the easiest comparison, how does the core PCE differ from the core consumer price index (CPI)? Since 2000, core CPI has averaged 2% vs. core PCE’s rate of 1.6%. What explains this discrepancy? According the Cleveland Fed’s research: “Both indexes calculate the price level by pricing a basket of goods. If the price of the basket goes up, the price index goes up.” Simple, right?
But the “baskets” aren’t the same. Each has different weights on some very important cost-of-living factors, particularly housing and medical care. Also, as per the Cleveland Fed, “The CPI is based on a survey of what households are buying; the PCE is based on surveys of what businesses are selling.” The greatest discrepancy between the CPI and PCE stems from healthcare and housing’s different weightings in each index.
The CPI has a 40% housing weight vs. just 23% in PCE. In PCE, medical care is 20% of the index compared to just 9% in CPI. Housing is the simpler of the two to explain. Persistent 3-4% annual rent gains speak to its outsized impact on the CPI relative to PCE.
As for healthcare, the CPI only covers out of pocket expenses on those goods and services bought. PCE includes these but also those expenses paid by a 3rd party, such as employer-provided health insurance, Medicare and Medicaid. Anyone who has spoken to a doctor should know that reimbursement rates have been on a perpetual spiral downwards.
The government’s de facto ‘price fixing’ of medical care costs has kept a lid on PCE relative to CPI.It’s also put the ‘arbitrary’ in the Fed’s senseless insistence on the importance of hitting a 2% target of a flawed metric.
Happily, all of this talk is meaningless as even the core PCE is at the cusp of piercing the 2% ceiling. As you can see in this neat table, tepid gains of as little as 0.14 percent a month would put the Fed officials on target by July. Any faster pace gets them there that much sooner. MoM run rate Month Core PCE hits 2% 0.14-0.15 Jul 0.16 Jun 0.17-0.24 May 0.25 Apr
With all of this as a preamble, you now know why Fed officials have raised their voices in concert to ask one question: “Shall we play a range?” It may appear that talk of aiming for a target inflation range of between 1.5%-2.5% gives the Fed leeway to raise interest rates to a greater degree to fend off burgeoning price pressures.
But how does the mirror image of this logic look? Come the next slowdown, the Fed can hold interest rates lower for even longer than ever before with a higher target based on a still-arbitrary measure. In other words, let’s make matters worse by raising the ceiling under the guise of even more sound econometric theory.