Fed’s inflation target – HubbardOBrienEconomics.com Blog

CPI Inflation for September Slightly Below Forecasts but Still Above Target

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As we’ve noted in recent blog posts (here and here), the shutdown of the federal government has interrupted the release of government data, including the “Employment Situation” report prepared monthly by the Bureau of Labor Statistics (BLS). The federal government made an exception for the BLS report on the consumer price index (CPI) because annual cost-of-living increases in Social Security payments are determined by the average inflation rate in the CPI during July, August, and September.

Accordingly, today (October 24), the Bureau of Labor Statistics (BLS) released its report on the consumer price index (CPI) for September. The following figure compares headline CPI inflation (the blue line) and core CPI inflation (the red line).

The headline inflation rate, which is measured by the percentage change in the CPI from the same month in the previous year, was 3.0 percent in September, up from 2.9 percent in August.
The core inflation rate, which excludes the prices of food and energy, was also 3.0 percent in September, down slightly from 3.1 percent in August.

Headline inflation and core inflation were both slightly lower than the 3.1 rate for both measures that economists had expected.

In the following figure, we look at the 1-month inflation rates for headline and core inflation—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year. Calculated as the 1-month inflation rate, headline inflation (the blue line) declined from the very high rate of 4.7 percent in August to the still high rate of 3.8 percent in September. Core inflation (the red line) declined from 4.2 percent in August to 2.8 percent in September.

The 1-month and 12-month inflation rates are both indicating that inflation remains well above the Fed’s 2 percent annual inflation target in September. Core inflation—which is often a good indicator of future inflation—in particular has been running well above target during the last three months.

Of course, it’s important not to overinterpret the data from a single month. The figure shows that the 1-month inflation rate is particularly volatile. Also note that the Fed uses the personal consumption expenditures (PCE) price index, rather than the CPI, to evaluate whether it is hitting its 2 percent annual inflation target.

Does the increase in inflation represent the effects of the increases in tariffs that the Trump administration announced on April 2? (Note that many of the tariff increases announced on April 2 have since been reduced.) The following figure shows 12-month inflation in durable goods—such as furniture, appliances, and cars—which are likely to be affected directly by tariffs, all core goods, and core services. Services are less likely to be affected by tariffs.. To make recent changes clearer, we look only at the months since January 2022. In August, inflation in durable goods declined slightly to 1.8 percent in September from 1.9 percent in August. Inflation in core goods was unchanged in September at 1.5 percent. Inflation in core services fell slightly in September to 3.5 percent from 3.6 percent in August.

The following figure shows 1-month inflation in the prices of these products, which may makes clearer the effects of the tariff increases. In September, durable goods inflation was a high 4.0 percent, although down from 5.1 percent in August. Core goods inflation in September was 2.7 percent, down from 3.4 percent in August. Core service inflation was 2.9 percent in August, down from 4.3 percent in August.

To better estimate the underlying trend in inflation, some economists look at median inflation and trimmed mean inflation.

Median inflation is calculated by economists at the Federal Reserve Bank of Cleveland and Ohio State University. If we listed the inflation rate in each individual good or service in the CPI, median inflation is the inflation rate of the good or service that is in the middle of the list—that is, the inflation rate in the price of the good or service that has an equal number of higher and lower inflation rates.
Trimmed-mean inflation drops the 8 percent of goods and services with the highest inflation rates and the 8 percent of goods and services with the lowest inflation rates.

The following figure shows that 12-month trimmed-mean inflation (the blue line) was 3.2 percent in September, down slightly from 3.3 August. Twelve-month median inflation (the red line) 3.5 percent in September, down slightly from 3.6 in August.

The following figure shows 1-month trimmed-mean and median inflation. One-month trimmed-mean inflation declined from 3.2 percent in August to 2.4 percent in September. One-month median inflation declined from 3.4 percent in August to 2.4 percent in September. These data are consistent with the view that inflation is still running above the Fed’s 2 percent target.

With inflation running above the Fed’s 2 percent annual target, we wouldn’t typically expect that the Fed’s policymaking Federal Open Market Committee (FOMC) would cut its target for the federal funds rate at its October 28–29 meeting. At this point, though, it seems likely that the FOMC will “look through” the higher inflation rates of the last few months because the higher rates may be largely attributable to one-time price increases caused by tariffs. Committee members have signaled that they are likely to cut their target for the federal funds rate by 0.25 percentage point (25 basis points) at the conclusion of next week’s meeting.

This morning, investors who buy and sell federal funds futures contracts assign a probability of 96.7 percent to the FOMC cutting its target for the federal funds rate at that meeting by 25 basis points from its current target range of 4.00 percent to 4.25 percent. Investors assign a 95.9 percent probability of the committee cutting its target by an additional 25 basis points to 3.50 percent to 3.75 percent at its December 9–10 meeting. If persistently high inflation rates reflect more than just the temporary effects of tariffs, these rate cuts will make it unlikely that the Fed will reach its 2 percent inflation target anytime soon.

Real GDP Growth Revised Up and PCE Inflation Running Slightly Below Expectations

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Today (September 26), the Bureau of Economic Analysis (BEA) released monthly data on the personal consumption expenditures (PCE) price index as part of its “Personal Income and Outlays” report. Yesterday, the BEA released its revised estimate of real GDP growth in the second quarter. Taken together, the two reports show that economic growth remains realtively strong and that inflation continues to run above the Fed’s 2 percent annual target.

Taking the inflation report first, the following figure shows headline PCE inflation (the blue line) and core PCE inflation (the red line)—which excludes energy and food prices—for the period since January 2018, with inflation measured as the percentage change in the PCE from the same month in the previous year. In August, headline PCE inflation was 2.7 percent, up from 2.6 percent in July. Core PCE inflation in August was 2.9 percent, unchanged from July. Headline PCE inflation was equal to the forecast of economists surveyed, while core PCE inflation was slightly lower than forecast.

The following figure shows headline PCE inflation and core PCE inflation calculated by compounding the current month’s rate over an entire year. (The figure above shows what is sometimes called 12-month inflation, while this figure shows 1-month inflation.) Measured this way, headline PCE inflation increased from 2.0 percent in July to 3.2 percent in August. Core PCE inflation declined slightly from 2.9 percent in July to 2.8 percent in August. So, both 1-month and 12-month PCE inflation are telling the same story of inflation being well above the Fed’s target. The usual caution applies that 1-month inflation figures are volatile (as can be seen in the figure). In addition, these data likely reflect higher prices resulting from the tariff increases the Trump administration has implemented. Once the one-time price increases from tariffs have worked through the economy, inflation may decline. It’s not clear, however, how long that may take and President Trump indicated yesterday that he may impose new tariffs on pharmaceuticals, large trucks, and furniture.

Fed Chair Jerome Powell has frequently mentioned that inflation in non-market services can skew PCE inflation. Non-market services are services whose prices the BEA imputes rather than measures directly. For instance, the BEA assumes that prices of financial services—such as brokerage fees—vary with the prices of financial assets. So that if stock prices fall, the prices of financial services included in the PCE price index also fall. Powell has argued that these imputed prices “don’t really tell us much about … tightness in the economy. They don’t really reflect that.” The following figure shows 12-month headline inflation (the blue line) and 12-month core inflation (the red line) for market-based PCE. (The BEA explains the market-based PCE measure here.)

Headline market-based PCE inflation was 2.4 percent in August, unchanged from July. Core market-based PCE inflation was 2.6 percent in August, also unchanged from July. So, both market-based measures show inflation as stable but above the Fed’s 2 percent target.

In the following figure, we look at 1-month inflation using these measures. One-month headline market-based inflation increase sharply to 2.5 percent in August from 0.9 percent in July. One-month core market-based inflation increased slightly to 1.9 percent in August from 1.8 percent in July. As the figure shows, the 1-month inflation rates are more volatile than the 12-month rates, which is why the Fed relies on the 12-month rates when gauging how close it is coming to hitting its target inflation rate.

Inflation running above the Fed’s 2 percent target is consistent with relatively strong growth in real GDP. The following figure shows compound annual rates of growth of real GDP, for each quarter since the first quarter of 2023. The value for the second quarter of 2025 is the BEA’s third estimate. This revised estimate increased the growth rate of real GDP to 3.8 percent from the second estimate of 3.3 percent.

The most important contributor to real GDP growth was growth in real personal consumption expenditures, which, as shown in the following figure, increased aat compound annual rate of 2.5 percent in the second quarter, up from 0.6 percent in the first quarter.

High interest rates continue to hold back residential construction, which declined by a compound annual rate of 5.1 percent in the second quarter after declining 1.0 percent in the first quarter.

Business investment in structures, such as factories and office buildings, continued a decline that began in the first quarter of 2024.

Will the relatively strong growth in real GDP in the second quarter continue in the third quarter? Economists at the Federal Reserve Bank of Atlanta prepare nowcasts of real GDP. A nowcast is a forecast that incorporates all the information available on a certain date about the components of spending that are included in GDP. The Atlanta Fed calls its nowcast GDPNow. As the following figure from the Atlanta Fed website shows, today the GDPNow forecast is for real GDP to grow at an annual rate of 3.9 percent in the third quarter.

Finally, the macroeconomic data released in the last two days has had realtively little effect on the expectations of investors trading federal funds rate futures. Investors assign an 89.8 percent probability to the Federal Open Market Committee (FOMC) cutting its target for the federal funds rate at its meeting on October 28–29 by 0.25 percentage point (25 basis points) from its current range of 4.00 percent to 4.25 percent. That probability is only slightly lower than 91.9 percent probaiblity that investors had assigned to a 25 basis point cut a week ago. However, the probability of the committee cutting its target rate by another 25 basis points at its December 9–10 fell to 67.0 percent today from 78.6 percent one week ago.

Unusual FOMC Meeting Leads to Expected Result of Rate Cut

Photo of Fed Chair Jerome Powell from federalreserve.gov

Today’s meeting of the Federal Reserve’s policymaking Federal Open Market Committee (FOMC) occurred against a backdrop of President Trump pressuring the committee to reduce its target for the federal funds rate. In a controversial move, Trump nominated Stephen Miran, chair of Council of Economic Advisers (CEA), to fill an open seat on the Fed’s Board of Governors. Miran took a leave of absence from the CEA rather than resign his position, which made him the first member of the Board of Governors in decades to maintain an appointment elsewhere in the executive branch while serving on the Board. In addition, Trump had fired Governor Lisa Cook on the grounds that she had committed fraud in applying for a mortgage at a time before her appointment to the Board. Cook denied the charge and a federal appeals court sustained an injunction allowing her to participate in today’s meeting.

As most observers had expected, the committee decided today to lower its target for the federal funds rate from a range of 4.25 percent to 4.50 percent to a range of 4.00 percent to 4.25 percent—a cut of 0.25 percentage point, or 25 basis points. The members of the committee voted 11 to 1 for the 25 basis point cut with Miran dissenting because he preferred a 50 basis point cut.

The following figure shows, for the period since January 2010, the upper bound (the blue line) and lower bound (the green line) for the FOMC’s target range for the federal funds rate and the actual values of the federal funds rate (the red line) during that time. Note that the Fed has been successful in keeping the value of the federal funds rate in its target range. (We discuss the monetary policy tools the FOMC uses to maintain the federal funds rate in its target range in Macroeconomics, Chapter 15, Section 15.2 (Economics, Chapter 25, Section 25.2).)

After the meeting, the committee also released a “Summary of Economic Projections” (SEP)—as it typically does after its March, June, September, and December meetings. The SEP presents median values of the 19 committee members’ forecasts of key economic variables. The values are summarized in the following table, reproduced from the release. (Note that only 5 of the district bank presidents vote at FOMC meetings, although all 12 presidents participate in the discussions and prepare forecasts for the SEP.)

There are several aspects of these forecasts worth noting:

Committee members slightly increased their forecasts of real GDP growth for each year from 2025 through 2027. Committee members also slightly decreased their forecasts of the unemployment rate in 2026 and 2027. They left their forecast of unemployment in the fourth quarter of 2025 unchanged at 4.5 percent. (The unemployment rate in August was 4.3 percent.)
Committee members left their forecasts for personal consumption expenditures (PCE) price inflation unchanged for 2025 and 2026, while raising their forecast for 2026 from 2.4 percent to 2.6 percent. Similarly, their forecasts of core PCE inflation were unchanged for 2025 and 2027 but increased from 2.4 percent to 2.6 percent for 2026. The committee does not expect that PCE inflation will decline to the Fed’s 2 percent annual target until 2028.
The committee’s forecast of the federal funds rate at the end of 2025 was lowered from 3.9 percent in June to 3.6 percent today. They also lowered their forecast for federal funds rate at the end of 2026 from 3.6 percent to 3.4 pecent and at the end of 2027 from 3.4 percent to 3.1 percent.

Prior to the meeting there was much discussion in the business press and among investment analysts about the dot plot, shown below. Each dot in the plot represents the projection of an individual committee member. (The committee doesn’t disclose which member is associated with which dot.) Note that there are 19 dots, representing the 7 members of the Fed’s Board of Governors and all 12 presidents of the Fed’s district banks.

The plots on the far left of the figure represent the projections of each of the 19 members of the value of the federal funds rate at the end of 2025. Ten of the 19 members expect that the committee will cut its target range for the federal funds rate by at least 50 basis points in its two remaining meetings this year. That narrow majority makes it likely that an unexpected surge in inflation during the next few months might result in the target range being cut by only 25 basis points or not cut at all. Members of the business press and financial analysts are expecting tht the committee will implement a 25 basis point cut in each of its last two meetings this year.

During his press conference following the meeting, Powell indicated that the recent increase in inflation was largely due to the effects of the increase in tariff rates that the Trump administration began implementing in April. (We discuss the recent data on inflation in this post.) Powell indicated that committee members expect that the tariff increases will cause a one-time increase in the price level, rather than causing a long-term increase in the inflation rate. Powell also noted recent slow growth in real GDP and employment. (We discuss the recent employment data in this blog post.) As a result, he said that the shift in the “balance of risks” caused the committee to believe that cutting the target for the federal funds rate was warranted to avoid the possibility of a significant rise in the unemployment rate.

The next FOMC meeting is on October 28–29 by which time the status of Lisa Cook on the committee may have been clarified. It also seems likely that President Trump will have named the person he intends to nominate to succeed Powell as Fed chair when Powell’s term ends on May 15, 2026. (Powel’s term on the Board doesn’t end until January 31, 2028, although Fed chairs typically resign from the Board if they aren’t reappointed as chair). And, of course, additional data on inflation and unemployment will also have been released.

Solved Problem: The Fed and the Value of Money

Supports: Macroeconomics, Chapter 15, Economics, Chapter 25, Essentials of Economics, Chapter 17, and Money, Banking, and the Financial System, Chapter 15.

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In a book review in the Wall Street Journal, the financial writer James Grant referred to “the Federal Reserve’s goal to cheapen the dollar by 2% a year.”

Briefly explain what “cheapen the dollar” means.
Briefly explain what Grant means by writing that the Fed has a “goal to cheapen the dollar by 2% a year.”
Do you agree with Grant that the Fed has this goal? Briefly explain.

Solving the Problem
Step 1: Review the chapter material. This problem is about the economic effects of the Federal Reserve’s policy goal of a 2 percent annual inflation rate, so you may want to review Chapter 15, Section 15.5, “A Closer Look at the Fed’s Setting Monetary Policy Targets.”

Step 2: Answer part a. by explaining what “cheapen the dollar” means. Judging from the context, “cheapen the dollar” means to reduce the purchasing power of a dollar. Whenever inflation occurs, the amount of goods and services a dollar can purchase declines. If the inflation rate in a year is 10 percent, than at the end of the year $1,000 can buy 10 percent fewer goods and services than it could at the beginning of the year.

Step 3: Answer part b. by expalining what Grant means by the Fed having a goal of cheapening the dollar by 2 percent a year. Congress has given a dual mandate of high employment and price stability. Since 2012, the Fed has interpreted a 2 percent annual inflation rate as meeting its mandate for price stability. So, Grant means that the Fed’s 2 percent annual inflation goal in effect is also a goal to cheapen—or reduce the purchasing power of the dollar—by 2 percent a year.

Step 4: Answer part c. by explaining whether you agree with Grant that the Fed has a goal of cheapening the dollar by 2 percent a year. As explained in the answer to part b., there is a sense in which Grant is correct; the Fed’s goal of a 2 percent inflation rate is a goal of allowing the purchasing power of the dollar to decline by 2 percent a year. One complication, however, is that most economists believe that changes in price indexes such as the consumer price index (CPI) and the personal consumption expenditures (PCE) price index overstate the actual amount of inflation occurring in the economy. As we discuss in Macroeconomics, Chapter 9, Section 9.4 (Economics, Chapter 19, Section 19.4, and Essentials of Economics, Chapter 13, Section 13.4), there are several biases that cause price indexes to overstate the true inflation rate; the most important of the biases is the failure of price indexes to take fully into account improvements over time in the quality of many goods and services. If increases in price indexes are overstating the inflation rate by one percentage point, then the Fed’s goal of a 2 percent inflation rate results in the dollar losing 1 percent—rather than 2 percent—of its purchasing power over time, corrected for changes in quality.

Surprisingly Strong CPI Report

Photo courtesy of Lena Buonanno.

As we’ve discussed in several blog posts (for instance, here and here), recent macro data have been consistent with the Federal Reserve being close to achieving a soft landing. The Fed’s increases in its target for the federal funds rate have slowed the growth of aggregate demand sufficiently to bring inflation closer to the Fed’s 2 percent target, but haven’t, to this point, slowed the growth of aggregate demand so much that the U.S. economy has been pushed into a recession.

By January 2024, many investors in financial markets and some economists were expecting that at its meeting on March 19-20, the Fed’s Federal Open Market Committee would be cutting its target for the federal funds. However, members of the committee—notably, Chair Jerome Powell—have been cautious about assuming prematurely that inflation had, in fact, been brought under control. In fact, in his press conference on January 31, following the committee’s most recent meeting, Powell made clear that the committee was unlikely to reduce its target for the federal funds rate at its March meeting. Powell noted that “inflation is still too high, ongoing progress in bringing it down is not assured, and the path forward is uncertain.”

Powell’s caution seemed justified when, on February 2, the Bureau of Labor Statistics (BLS) released its most recent “Employment Situation Report” (discussed in this post). The report’s data on growth in employment and growth in wages, as measured by the change in average hourly earnings, might be indicating that aggregate demand is growing too rapidly for inflation to continue to decline.

The BLS’s release today (February 13) of its report on the consumer price index (CPI) (found here) for January provided additional evidence that the Fed may not yet have put inflation on a firm path back to its 2 percent target. The average forecast of economists surveyed before the release of the report was that the increase in the version of the CPI that includes the prices of all goods and services in the market basket—often called headline inflation—would be 2.9 percent. (We discuss how the BLS constructs the CPI in Macroeconomics, Chapter 9, Section 19.4, Economics, Chapter 19, Section 19.4, and Essentials of Economics, Chapter 3, Section 13.4.) As the following figure shows, headline inflation for January was higher than expected at 3.1 percent (measured by the percentage change from the same month in the previous year), while core inflation—which excludes the prices of food and energy—was 3.9 percent. Headline inflation was lower than in December 2023, while core inflation was almost unchanged.

Although the values for January might seem consistent with a gradual decline in inflation, that conclusion may be misleading. Headline inflation in January 2023 had been surprisingly high at 6.4 percent. Hence, the comparision between the value of the CPI in January 2024 with the value in January 2023 may be making the annual CPI inflation rate seem artificially low. If we look at the 1-month inflation rate for headline and core inflation—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—the values are more concerning, as indicated in the following figure. Headline CPI inflation is 3.7 percent and core CPI inflation is 4.8 percent.

Even more concerning is the path of inflation in the prices of services. Chair Powell has emphasized that as supply chain problems have gradually been resolved, inflation in the prices of goods has been rapidly declining. But inflaion in services hasn’t declined nearly as much. Last summer he stated the point this way:

“Part of the reason for the modest decline of nonhousing services inflation so far is that many of these services were less affected by global supply chain bottlenecks and are generally thought to be less interest sensitive than other sectors such as housing or durable goods. Production of these services is also relatively labor intensive, and the labor market remains tight. Given the size of this sector, some further progress here will be essential to restoring price stability.”

The following figure shows the 1-month inflation rate in services prices. The figure shows that inflation in services has been above 4 percent in every month since July 2023. Inflation in services was a very high 8.7 percent in January. Clearly such large increases in the prices of services aren’t consistent with the Fed meeting its 2 percent inflation target.

How should we interpret the latest CPI report? First, it’s worth bearing in mind that a single month’s report shouldn’t be relied on too heavily. There can be a lot of volatility in the data month-to-month. For instance, inflation in the prices of services jumped from 4.7 percent in December to 8.7 percent in January. It seems unlikely that inflation in the prices of services will continue to be over 8 percent.

Second, housing prices are a large component of service prices and housing prices can be difficult to measure accurately. Notably, the BLS includes in its measure the implicit rental price that someone who owns his or her own home pays. The BLS calculates that implict rental price by asking consumers who own their own homes the following question: “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” (The BLS discusses how it measures the price of housing services here.) In practice, it may be difficult for consumers to accurately answer the question if very few houses similar to theirs are currently for rent in their neighborhood.

Third, the Fed uses the personal consumption expenditures (PCE) price index, not the CPI, to gauge whether it is achieving its 2 percent inflation target. The Bureau of Economic Analysis (BEA) includes the prices of more goods and services in the PCE than the BLS includes in the CPI and measures housing services using a different approach than that used by the BLS. Although inflation as measured by changes in the CPI and as measured by changes in the PCE move roughly together over long periods, the two measures can differ significantly over a period of a few months. The difference between the two inflation measures is another reason not to rely too heavily on a single month’s CPI data.

Despite these points, investors on Wall Street clearly interpreted the CPI report as bad news. Investors have been expecting that the Fed will soon cut its target for the federal funds rate, which should lead to declines in other key interest rates. If inflation continues to run well above the Fed’s 2 percent target, it seems likely that the Fed will keep its federal funds target at its current level for longer, thereby slowing the growth of aggregate demand and raising the risk of a recession later this year. Accordingly, the Dow Jones Industrial Average declined by more than 500 points today (February 13) and the interest rate on the 10-year Treasury note rose above 4.3 percent.

The FOMC has more than a month before its next meeting to consider the implications of the latest CPI report and the additional macro data that will be released in the meantime.