A quick look at a timely topic of interest - with a brief review of why it could matter to investors.

Chart of the Week

June 29, 2015

Inflation: What the Fed Sees
CPE and CPI inflation measures, May 2010-May 2015

chart

Source: Bloomberg, as of 6/26/2015. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The bottom line:

  • To understand why the Fed did not act to raise interest rates in June, one need look no further than the latest inflation figures – particularly Core PCE (personal consumption expenditure) index, the Fed's preferred inflation metric.
  • PCE is similar to the more widely publicized CPI (consumer price index) in that it tracks changes in the cost of a hypothetical basket of consumer spending.
  • However, PCE weights the various components very differently (with less emphasis on housing costs and more on medical care costs, among other things), in ways that arguably provide a more comprehensive view of spending.
  • Core PCE, the Fed's preferred measure, filters out energy and food spending, on the principle that these areas are subject to greater short-term price fluctuations, and can distort the view of overall inflation trends.
  • After a modest upturn early this year, Core PCE has fallen for three consecutive months to a May reading just below 1.24% – nowhere near the 2% inflation level that the Fed has previously cited as a policy goal.
  • Core CPI also took a dive in May, declining to 1.7% after a series of encouraging readings.
  • Of course, employment also figures into the Fed's decision-making – and in contrast, the most recent news has been encouraging. Inflation-adjusted average weekly earnings rose 2.3% year-on-year in May; private-industry positions waiting to be filled jumped to 4.89 mn in April, outpacing the number of workers hired for the first time on record.
  • Data aside, the Fed has reasons to be concerned about waiting too long to begin normalizing rates. If growth were to accelerate quickly, there's a danger that current policies could stoke the fires of inflation beyond what's desired for the longer term.
  • What's more, starting sooner than later would allow the Fed more time to normalize rates at a pace that will be less disruptive to the economy and markets.
  • That's led many observers to see an initial increase as soon as September or December; but whatever the Fed decides, Core PCE data will be crucial.

The chart:

  • The chart shows the how the major inflation measures (PCE, Core PCE, CPI and Core CPI) have behaved over the last 5 years in relation to the 2% inflation level that the Fed has identified as a current policy goal.
  • By and large, the CPI and Core CPI figures have shown greater month to month volatility than CPE and Core CPE figures – one reason that CPE may be seen as a more reliable guide to longer term inflation trends.

Definitions:

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The Personal Consumption Expenditures (PCE) Price Index is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services. This index takes consumers' changing consumption due to prices into account, whereas the Consumer Price Index uses a fixed basket of goods with weightings that do not change over time. Core PCE excludes food & energy prices.

The Consumer Price Index (CPI) measures the average change in U.S. consumer prices over time in a fixed market basket of goods and services determined by the U.S. Bureau of Labor Statistics. Core CPI excludes the prices of food and energy.


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