Two closely watched inflation measures jumped in May and have been rising about 2 percent annually, leading to market speculation that interest rates could be rising sooner than expected. But the Fed more so relies on inflation represented by personal consumption expenditures (PCE)—the change in prices for consumer goods and services, that serves as the more comprehensive chain price indices. PCE is due out this week and is running well below the central bank’s 2 percent longer-run target.
Federal Reserve Chair Janet Yellen remains unfazed by the market chatter and quickly dismissed the uptick in monthly Consumer Price Index (CPI) reports as “noise,” dampening ongoing speculation that rising consumer prices could hasten a looming hike in interest rates.
While the Fed remains firmly committed to holding inflation at 2 percent—stable and low inflation has long been embraced as the best way to promote sustainable economic growth—subtle changes in the Fed’s decision-making process have reduced the likelihood for surprising short-term developments to affect monetary policy. The Fed’s 2012 Statement on Longer-run Goals and Monetary Policy Strategy, directs policymakers to base their decisions on long-range forecasts, not the most recent headlines. This spring’s jump in consumer prices is unlikely to affect the Fed, as few economists are confident these recent figures herald the beginning of a sustained period of inflation.
While some critics claim that the Fed’s preference for considering economic forecasts introduces an unnecessary layer of subjectivity and speculation into the decision-making process, even the most objective measures of inflation often depend on subjective assumptions. For example, the Bureau of Labor Statistics’ CPI, which measures inflation through surveys of current prices, is ultimately based on a “representative basket” of consumer goods, the contents of which are partially determined through telephone surveys polling consumers about their shopping habits. Ultimately, this means the CPI is partially-based on the unreliable memories of individuals willing to discuss their recent retail purchases with a stranger over the phone.
At the same time, the CPI does not reflect all costs. One notable weakness is that it represents only out-of-pocket healthcare costs—it doesn’t reflect costs born by the public sector for Medicare and Medicaid, nor the costs paid by the private health insurance system. This discrepancy accounts for the large divergence between the CPI and PCE inflation measures. Understanding the methodology of calculating these indicators doesn’t diminish the CPI’s reliability and precision as an indicator of a healthy economy, but simply highlights the delicate interplay between objective and subjective information sources and the role they play in developing well-crafted economic models. From long-range economic forecasts to real-time price surveys, the true rate of inflation must be sifted from price fluctuations driven by factors unrelated to monetary policy. This is why measures of core inflation disregard food and energy prices, despite their outsized effect on consumer budgets. Although politicians often accuse economists of willfully ignoring the impact of rising fuel and food prices to minimize the official inflation rate, increases in the price of gas are typically driven by geopolitics, not monetary policy. Similarly, volatile food prices are more likely to result from aberrant weather patterns than interest rates, which is why they’re excluded from the inflation calculation, aimed at specifically measuring economic valuation changes and impacts. For these reasons, inflation measures that exclude the volatile price swings in food and energy prices tend to provide more insights about potential underlying inflation pressures.
Chair Yellen’s rejection of raising interest rates as a prophylaxis against inflation reflects greater concerns about the larger economic picture. As long as full employment remains a distant goal, rampant inflation is highly unlikely. Today, around eight million workers are currently unemployed, underemployed or discouraged. These workers represent a tremendous untapped economic potential—and considerable room for noninflationary growth. It would not be surprising if the Fed tolerates brief periods of above-target inflation until the ranks of idle workers are thinned.