inflation – Page 8 – HubbardOBrienEconomics.com Blog

Latest PCE Report Indicates that Inflation May Be Approaching the Fed’s Target

The result when asking GTP-4o to generate “an image illustrating inflation.”

Inflation, as measured by changes in the personal consumption expenditures (PCE) price index, continued a slow decline that began in March. (The Fed uses annual changes in the PCE price index to evaluate whether it’s meeting its 2 percent annual inflation target.) On August 30, the Bureau of Economic Analysis (BEA) released its “Personal Income and Outlays” report for July, which contains monthly PCE data.

The following figure shows PCE inflation (blue line) and core PCE inflation (red line)—which excludes energy and food prices—for the period since January 2015 with inflation measured as the percentage change in the PCE from the same month in the previous year. Measured this way, in July PCE inflation (the blue line) was 2.5 percent, the same as in June. Core PCE inflation (the red line) in July was 2.6 percent, which was also unchanged from June.

The following figure shows 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, PCE inflation rose in July to 1.7 percent from 0.7 percent in July—although higher in July, inflation was below the Fed’s 2 percent target in both months. Core PCE inflation was 2.0 percent in July, which was unchanged from June. These data indicate that inflation has been at or below the Fed’s target for the last three months.

The following figure shows another way of gauging inflation by including the 12-month inflation rate in the PCE (the same as shown in the figure above), inflation measured using only the prices of the services included in the PCE (the green line), and the trimmed mean rate of PCE inflation (the red line). Fed Chair Jerome Powell and other members of the Federal Open Market Committee (FOMC) have said that they are concerned by the persistence of elevated rates of inflation in services. The trimmed mean measure is compiled by economists at the Federal Reserve Bank of Dallas by dropping from the PCE the goods and services that have the highest and lowest rates of inflation. It can be thought of as another way of looking at core inflation by excluding the prices of goods and services that had particularly high or particularly low rates of inflation during the month.

Inflation using the trimmed mean measure was 2.7 percent in July (calculated as a 12-month inflation rate), down only slightly from 2.8 percent in June—and still above the Fed’s target inflation rate of 2 percent. Inflation in services remained high in July at 3.7 percent, although down from 3.9 percent in June.

On balance, taking together these various measures, inflation seems on track to return to the Fed’s 2 percent target. As we noted in this earlier post, last week in a speech at the Federal Reserve Bank of Atlanta’s monetary policy symposium in Jackson Hole, Wyoming , Fed Chair Jerome Powell all but confirmed that the the Fed’s policy-maiking Federal Open Market Committee (FOMC) will cut its target for the federal funds rate at its next meeting on September 17-18. There was nothing in this latest PCE report to reduce the likelihood of the FOMC cutting its target at that meeting by an expected 0.25 percent point from a range of 5.25 percent to 5.50 percent to a range of 5.00 percent to 5.25 percent. There also is nothing in the report that would increase likelihood that the committee will cut its target by 0.50 percentage point, as many investors expected following the weak employment report released by the Bureau of labor Statistics (BLS) at the beginning of August. (We discuss this report and the reaction among investors in this post.)

Glenn’s Interview with Jim Pethokoukis

Glenn discusses Fed policy, the state of the U.S economy, economic growth, China in the world economy, industrial policy, protectionism, and other topics in this episode of the Political Economy podcast from the American Enterprise Institute.

https://podcasts.apple.com/us/podcast/glenn-hubbard-a-pro-growth-policy-agenda/id589914386?i=1000665131415

Fed Chair Powell Indicates that Rate Cuts Will Begin Soon

Photo of Federal Reserve Chair Jerome Powell from federalreserve.gov

Federal Reserve chairs often take the opportunity of the Kansas City Fed’s annual monetary policy symposium held in Jackson Hole, Wyoming to provide a summary of their views on monetary policy and on the state of the economy. In speeches, Fed chairs are careful not to preempt decisions of the Federal Open Market Committee (FOMC) by stating that policy changes will occur that the committee hasn’t yet agreed to. In his speech at Jackson Hole on Friday (August 23), Powell came about as close as Fed chairs ever do to announcing a policy change in a speech.

In the speech, Powell indicated that: “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.” The statement is effectively an announcement that the FOMC will reduce its target for the federal funds rate at its next meeting on September 17-18. By referring to “the timing and pace of rate cuts,” Powell was indicating that the FOMC was likely to eventually reduce its target for the federal funds rate well below its current 5.25 percent to 5.50 percent, although the reductions will be spread out over a number of meetings.

The minutes of the FOMC’s last meeting on July 30-31 were released on August 21. The minutes stated that: “The vast majority [of committee members] observed that, if the data continued to come in about as expected, it would likely be appropriate to ease policy at the next meeting.” The apparent consensus at the July meeting that the target for the federal funds rate should be reduced at the September meeting was likely the key reason why Powell was so forthright in his speech.

In his speech, Powell summarized his views on the reasons that inflation accelerated in 2021 and why it has slowly declined since reaching a peak in the summer of 2022:

“[The analysis of events that Powell supports] attributes much of the increase in inflation to an extraordinary collision between overheated and temporarily distorted demand and constrained supply. While researchers differ in their approaches and, to some extent, in their conclusions, a consensus seems to be emerging, which I see as attributing most of the rise in inflation to this collision. All told, the healing from pandemic distortions, our efforts to moderate aggregate demand, and the anchoring of expectations have worked together to put inflation on what increasingly appears to be a sustainable path to our 2 percent objective.”

As he has over the past three years, Powell emphasized the importance of expectations having remained “anchored,” meaning that households and firms continued to expect that the annual inflation rate would return to 2 percent, even when the current inflation rose far above that rate. We discuss how expectations of inflation affect the current inflation rate in Macroeconomics, Chapter 17 (Economics, Chapter 27).

Where Did 818,000 Jobs Go?

Image of “people attending a job fair” generated by GTP-4o

On Wednesday, August 21, the Bureau of Labor Statistics (BLS) issued revised estimates of the increase in employment, as measured by the establishment survey, over the period from April 2023 through March 2024. The BLS had initially estimated that on average during that period net employment had increased by 242,000 jobs per month. The revision lowered this estimate by 28 percent to an average of only 174,000 net new jobs created per month. The difference between those two monthly averages means that the U.S. economy had generated a total of 818,000 fewer jobs during that period.

Why does the BLS have to revise its employment estimates? As we discuss in Macroeonomics, Chapter 9, Section 9.1 (Economics, Chapter 19, Section 19.1) the initial estimates that the BLS issues each month in its “Employment Situation” reports are based on a sample of 300,000 establishments. The monthly data also rely on estimates of the number of employees at establishments that opened or closed during the month and on employment changes at establishments that failed to respond to the survey. In August of each year, the BLS issues revised employment estimates based on state unemployment insurance tax records, which are much more comprehensive than the original sample of establishments because nearly all employers are included.

Although this year’s revision is particularly large in absolute terms—the largest since 2009—it still represents only about 0.5 percent of the more than 158 million people employed in the U.S. economy. How will this revision affect the decision by the Federal Open Market Committee (FOMC) at its next meeting on September 17-18 to cut or maintain its target for the federal funds rate? The members of the committee were probably not surprised by the downward revision in the employment estimates, although they may have anticipated that the revision would be smaller. In five of the past six years, the BLS has revised its estimates of payroll employment downward in its annual benchmark revision.

In his press conference following the June 12 FOMC meeting, Fed Chair Jerome Powell observed that “you have payroll jobs still coming in strong, even though, you know, there’s an argument that they may be a bit overstated.” (Note that FOMC members don’t receive the data in BLS reports until the reports are publicly released.) As we noted in this recent post, even before the BLS revised its employment estimates downward, recent monthly increases were below the level likely needed to keep up with population growth—so-called breakeven employment growth. There was already a high likelihood that the FOMC intended to cut its target for the federal funds rate at its September meeting. The substantial downward revision in the employment data makes a cut nearly a certainty.

Chair Powell is scheduled to give a speech on Friday morning at the Kansas City Fed’s annual monetary policy symposium held in Jackson Hole, Wyoming. During that speech, he’s likely to give his reaction to the revised employment data—and the state of the labor market more generally.

CPI Inflation Is Lowest Since March 2021

Photo courtesy of Lena Buonanno

Today (August 14), the Bureau of Labor Statistics (BLS) released its monthly report on the consumer price index (CPI), which showed inflation falling below 3 percent for the first time since March 2021.

As the following figure shows, the inflation rate for July measured by the percentage change in the CPI from the same month in the previous month—headline inflation (the blue line)—was 2.9 percent down from 3.0 percent in June. Core inflation (the red line)—which excludes the prices of food and energy—was 3.2 percent in July, down from 3.3 percent in June.

As the following figure shows, 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—we see an increase in the inflation rate in July, but the increase is from the very low levels in June. Headline inflation (the blue line) increased from –0.7 percent in June (which means that consumer price actually fell that month) to 1.9 percent in July. Core inflation (the red line) increased from 0.8 percent in June to 2.o percent in July. Overall, we can say that, taking 1-month and 12 month inflation together, the U.S. economy seems on course for a soft landing—with the annual inflation rate returning to the Fed’s 2 percent target without the economy being pushed into a recession. (Note, though, that the Fed uses the personal consumption expenditures (PCE) price index, rather than the CPI in evaluating whether it is hitting its 2 percent inflation target.)

Federal Reserve Chair Jerome Powell and his colleagues on the policy-making Federal Open Market Committee (FOMC) have been closely following inflation in the price of shelter. The price of “shelter” in the CPI, as explained here, includes both rent paid for an apartment or house and “owners’ equivalent rent of residences (OER),” which is an estimate of what a house (or apartment) would rent for if the owner were renting it out. OER is included to account for the value of the services an owner receives from living in an apartment or house.

As the following figure shows, inflation in the price of shelter has been a significant contributor to headline inflation. The blue line shows 12-month inflation in shelter and the red line shows 1-month inflation in shelter. Twelve-month inflation in shelter continued its decline that began in the spring of 2023, falling from 5.1 percent in June to 5.0 percent July. One-month inflation in shelter—which is much more volatile than 12-month inflation in shelter—increased from 2.1 percent in June to 4.6 percent in July. The value for 1-month inflation in shelter may concern the members of the FOMC, but the continuing decline in in the less volatile 12-month inflation in shelter provides some reassurance that inflation in shelter is likely continuing to decline.

Finally, in order to get a better estimate of 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 good and services with the higherst inflation rates and the 8 percent of goods and services with the lowest inflation rates.

As the following figure (from the Federal Reserve Bank of Cleveland) shows, median inflation (the brown line) ticked up slightly from 4.2 percent in June to 4.3 percent in July. Trimmed mean inflation (the blue line) was unchanged in July at 3.3 percent. One conclusion from these data is that headline and core inflation may be somewhat understating the underlying rate of inflation.

For the past few weeks investores in financial markets have been expecting that recent inflation and employment data will lead the FOMC to cut its target for the federal funds at its next meeting on Septembe 17-18 .

Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk—such as a sudden increase in oil prices or in interest rates—and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banking, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart from the CME’s FedWatch Tool shows the current values from trading of federal funds futures.

The probabilities in the chart reflect investors’ predictions of what the FOMC’s target for the federal funds rate will be after the committee’s September meeting. The chart indicates that investors assign a probability of 35.5 percent to the FOMC cutting its target range for the federal funds rate by 0.50 percentage point from the current 5.25 prcent to 5.50 percent to 4.75 percent to 5.25 percent. Investors assign a much larger probability—64.5 percent—to the FOMC cutting its target range for the federal funds rate by 0.25 percentage point to 5.00 percent to 5.25 percent.

It would most likely require the next BLS “Employment Situation” report—which is scheduled for release on September 6—to show unexpected weakness for the FOMC to cut its target for the federal funds rate by more than 0.25 percentage point.

FOMC Holds Rate Target Steady While Hinting at a Cut at the September Meeting

Image of “Federal Reserve Chair Jerome Powell speaking at a podium” generated by GTP-4o.

At the conclusion of its July 30-31 meeting, the Federal Reserve’s policy-making Federal Open Market Committee (FOMC) voted unamiously to leave its target range for the federal funds rate unchanged at 5.25 percent to 5.5 percent. (The statement the FOMC issued following the meeting can be found here.)

In the statement Fed Chair Jerome Powell read at the beginning of his press conference after the meeting, Powell appeared to be repeating a position he has stated in speeches and interviews during the past month:

“We have stated that we do not expect it will be appropriate to reduce the target range for the federal funds rate until we have gained greater confidence that inflation is moving sustainably toward 2 percent. The second-quarter’s inflation readings have added to our confidence, and more good data would further strengthen that confidence. We will continue to make our decisions meeting by meeting.”

But in answering questions from reporters, he made it clear that—as many economists and Wall Street investors had already concluded—the FOMC was likely to reduce its target for the federal funds rate at its next meeting on September 17-18. Powell noted that recent data were consistent with the inflation rate continuing to decline toward the Fed’s 2 percent annual target. Powell summarized the consensus from the discussion among committee members as being that “the time was approaching for cutting rates.”

Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk—such as a sudden increase in oil prices or in interest rates—and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banking, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart from the CME’s FedWatch Tool shows the current values resulting from trading of federal funds futures.

The probabilities in the chart reflect investors’ predictions of what the FOMC’s target for the federal funds rate will be after the committee’s September meeting. The chart indicates that investors assign a probability of 100 percent to the FOMC cutting its federal funds rate target at this meeting. Investors assign a probability of 89.0 percent that the committee will cut its target by 0.25 percentage point and a probability of 11.0 percent that the commitee will cut its target by 0.50 percentage point. When asked at his press conference whether the committee had given any consideration to making a 0.50 percentage point cut in its target, Powell said that it hadn’t.

Powell stated that the latest data on wage increases had led the committee to conclude that the labor market was no longer a source of inflationary pressure. The morning of the press conference, the Bureau of Labor Statistics (BLS) released its latest report on the Employment Cost Index (ECI). As we’ve noted in earlier posts, as a measure of the rate of increase in labor costs, the FOMC prefers the ECI to average hourly earnings (AHE).

As a measure of how wages are increasing or decreasing during a particular period, AHE can suffer from composition effects because AHE data aren’t adjusted for changes in the mix of occupations workers are employed in. In contrast, the ECI holds the mix of occupations constant. The ECI does have the drawback that it is only available quarterly whereas the AHE is available monthly.

The following figure shows the percentage change in the ECI for all civilian workers from the same quarter in the previous year. The blue line looks only at wages and salaries, while the red line is for total compensation, including non-wage benefits like employer contributions to health insurance. The rate of increase in the wage and salary measure decreased slightly from 4.3 percent in the first quarter of 2024 to 4.2 percent in the second quarter of 2024. The rate of increase in compensation also declined slightly from 4.2 percent to 4.1 percent. As the figure shows, both measures continued their declines from the peak of wage inflation during the second quarter of 2022. In his press conference, Powell said that the this latest ECI report was a little better than the committee had expected.

Finally, Powell noted that the committee saw no indication that the U.S. economy was heading for a recession. He observed that: “The labor market has come into better balance and the unemployment rate remains low.” In addition, he said that output continued to grow steadily. In particular, he pointed to growth in real final sales to private domestic purchasers. This macro variable equals the sum of personal consumption expenditures and gross private fixed investment. By excluding exports, government purchases, and changes in inventories, final sales to private domestic purchasers removes the more volatile components of gross domestic product and provides a better measure of the underlying trend in the growth of output.

As the following figure shows, this measure of output has grown at an annual rate of more than 2.5 percent in each of the last three quarters. Output expanding at that rate is indicative of an economy that is neither overheating nor heading toward a recession.

At this point, unless macro data releases are unexpectedly strong or weak during the next six weeks, it seems nearly certain that at its September meeting the FOMC will reduce its target range for the federal funds rate by 0.25 percentage point.

How Should the Fed Interpret the Monthly Employment Reports?

Jerome Powell arriving to testify before Congress. (Photo from Bloomberg News via the Wall Street Journal.)

Each month the Bureau of Labor Statistics (BLS) releases its “Employment Situation” report. As we’ve discussed in previous blog posts, discussions of the report in the media, on Wall Street, and among policymakers center on the estimate of the net increase in employment that the BLS calculates from the establishment survey.

How should the members of the Fed’s policy-making Federal Open Market Committee interpret these data? For instance, the BLS reported that the net increases in employment in June was 206,000. (Always worth bearing in mind that the monthly data are subject to—sometimes substantial—revisions.) Does a net increase of employment of that size indicate that the labor market is still running hot—with the quantity of labor demanded by businesses being greater than the quantity of labor workers are supplying—or that the market is becoming balanced with the quantity of labor demanded roughly equal to the quantity of labor supplied?

On July 9, in testimony before the Senate Banking Committee indicated that his interpretation of labor market data indicate that: “The labor market appears to be fully back in balance.” One interpretation of the labor market being in balance is that the number of net new jobs the economy creates is enough to keep up with population growth. In recent years, that number has been estimated to be 70,000 to 100,000. The number is difficult to estimate with precision for two main reasons:

There is some uncertainty about the number of older workers who will retire. The more workers who retire, the fewer net new jobs the economy needs to create to accommodate population growth.
More importantly, estimates of population growth are uncertain, largely because of disagreements among economists and demographers over the number of immigrants who have entered the United States in recent years.

In calculating the unemployment rate and the size of the labor force, the BLS relies on estimates of population from the Census Bureau. In a January report, the Congressional Budget Office (CBO) argued that the Census Bureau’s estimate of the population of the United States is too low by about 6 million people. As the following figure from the CBO report indicates, the CBO believes that the Census Bureau has underestimated how much immigration has occurred and what the level of immigration is likely to be over the next few years. (In the figure, SSA refers to the Social Security Administration, which also makes forecasts of population growth.)

Some economists and policymakers have been surprised that low levels of unemployment and large monthly increases in employment have not resulted in greater upward pressure on wages. If the CBO’s estimates are correct, the supply of labor has been increasing more rapidly than is indicated by census data, which may account for the relative lack of upward pressure on wages. If the CBO’s estimates of population growth are correct, a net increase in employment of 200,000, as occured in June, may be about the number necessary to accommodate growth in the labor force. In other words, Chair Powell would be correct that the labor market was in balance in June.

In a recent publication, economists Nicolas Petrosky-Nadeau and Stephanie A. Stewart of the Federal Reserve Bank of San Francisco look at a related concept: breakeven employment growth—the rate of employment growth required to keep the unemployment rate unchanged. They estimate that high rates of immigration during the past few years have raised the rate of breakeven employment growth from 70,000 to 90,000 jobs per month to 230,000 jobs per month. This analysis would be consistent with the fact that as net employment increases have averaged 177,000 over the past three months—somewhat below their estimate of breakeven employment growth—the unemployment rate has increased from 3.8 percent to 4.1 percent.

Latest CPI Report Shows Inflation Continuing to Slow

Image of “a family shopping in a supermarket” generated by ChatGTP 4o.

In testifying before Congress this week, Federal Reserve Chair Jerome Powell indicated that the Fed’s policy-making Federal Open Market Committee (FOMC) was becoming more concerned that it not be too late in reducing its target for the federal funds rate:

“[I]n light of the progress made both in lowering inflation and in cooling the labor market over the past two years, elevated inflation is not the only risk we face. Reducing policy restraint too late or too little could unduly weaken economic activity and employment.”

Powell also noted that: “more good data would strengthen our confidence that inflation is moving sustainably toward 2 percent.” Today (July 11), Powell received more good data as the Bureau of Labor Statistics (BLS) released its monthly report on the consumer price index (CPI), which showed a further slowing in inflation.

As the following figure shows, the inflation rate for June measured by the percentage change in the CPI from the same month in the previous month—headline inflation (the blue line)—was 3.o percent down from 3.3 percent in May. Core inflation (the red line)—which excludes the prices of food and energy—was 3.3 percent in June, down from 3.4 percent in May.

As the following figure shows, 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 declines in the inflation rate are much larger. Headline inflation (the blue line) declined from 0.1 percent in May to –0.7 in June—consumer prices fell during June. Core inflation (the red line) declined from 2.0 percent in May to 0.8 percent in June. Overall, we can say that inflation has cooled further in June, bringing the U.S. economy closer to a soft landing—with the annual inflation rate returning to the Fed’s 2 percent target without the economy being pushed into a recession. (Note, though, that the Fed uses the personal consumption expenditures (PCE) price index, rather than the CPI in evaluating whether it is hitting its 2 percent inflation target.)

The FOMC has been looking closely at inflation in the price of shelter. The price of “shelter” in the CPI, as explained here, includes both rent paid for an apartment or house and “owners’ equivalent rent of residences (OER),” which is an estimate of what a house (or apartment) would rent for if the owner were renting it out. OER is included to account for the value of the services an owner receives from living in an apartment or house.

Finally, in order to get a better estimate of the underlying trend in inflation, some economists look at median inflation and trimmed mean inflation. Meadin 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 good and services with the higherst inflation rates and the 8 percent of goods and services with the lowest inflation rates.

As the following figure (from the Federal Reserve Bank of Cleveland) shows, both median inflation (the brown line) and trimmed mean inflation (the blue line) were somewhat higher than either headline CPI inflation or core CPI inflation. One conclusion from these data is that headline and core inflation may be somewhat understating the underlying rate of inflation.

Financial markets are interpreting the most inflation and employment data as indicating that at its meeting on Septembe 17-18 the FOMC is likely to cut its target range for the federal funds rate from the current 5.25 percent to 5.50 to 5.00 percent to 5.25 percent.

Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk—such as a sudden increase in oil prices or in interest rates—and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banking, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart from the CME’s FedWatch Tool shows the current values from trading of federal funds futures.

The probabilities in the chart reflect investors’ predictions of what the FOMC’s target for the federal funds rate will be after the committee’s September meeting. The chart indicates that investors assign a probability of only 8.1 percent to the FOMC leaving its federal funds rate target unchanged at its September meeting, but a 84.6 percent probability of the committee cutting its target by 0.25 percentage point (and a 7.3 percent probability of the committee cutting its target by 0.50 percent age point).

Latest PCE Report Shows Inflation Slowing

Chair Jerome Powell and other members of the Federal Open Market Committee (Photo from federalreserve.gov)

On Friday, June 28, the Bureau of Economic Analysis (BEA) released its “Personal Income and Outlays” report for April, which includes monthly data on the personal consumption expenditures (PCE) price index. Inflation as measured by annual changes in the consumer price index (CPI) receives the most attention in the media, but the Federal Reserve looks instead to inflation as measured by annual changes in the PCE price index to evaluate whether it’s meeting its 2 percent annual inflation target.

The following figure shows PCE inflation (blue line) and core PCE inflation (red line)—which excludes energy and food prices—for the period since January 2015 with inflation measured as the change in the PCE from the same month in the previous year. Measured this way, in May PCE inflation (the blue line) was 2.6 percent in May, down slightly from PCE inflation of 2.7 percent in April. Core PCE inflation (the red line) in May was also 2.6 percent, down from 2.8 percent in April.

The following figure shows 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, PCE inflation sharply declined from 3.2 percent in April to -0.1 percent in in May—meaning that consumer prices actually fell during May. Core PCE inflation declined from 3.2 percent in April to 1.0 percent in May. This decline indicates that inflation by either meansure slowed substantially in May, but data for a single month should be interpreted with caution.

The following figure shows another way of gauging inflation by including the 12-month inflation rate in the PCE (the same as shown in the figure above—although note that PCE inflation is now the red line rather than the blue line), inflation as measured using only the prices of the services included in the PCE (the green line), and the trimmed mean rate of PCE inflation (the blue line). Fed Chair Jerome Powell and other members of the Federal Open Market Committee (FOMC) have said that they are concerned by the persistence of elevated rates of inflation in services. The trimmed mean measure is compiled by economists at the Federal Reserve Bank of Dallas by dropping from the PCE the goods and services that have the highest and lowest rates of inflation. It can be thought of as another way of looking at core inflation by excluding the prices of goods and services that had particularly high or particularly low rates of inflation during the month.

Inflation using the trimmed mean measure was 2.8 percent in May (calculated as a 12-month inflation rate), down only slightly from 2.9 percent in April—and still well above the Fed’s target inflation rate of 2 percent. Inflation in services remained high in May at 3.9 percent, down only slightly from 4.0 percent in April.

This month’s PCE inflation data indicate that the inflation rate is still declining towards the Fed’s target, with the low 1-month inflation rates being particularly encouraging. But the FOMC will likely need additional data before deciding to lower the committee’s target for the federal funds rate, which is currently 5.25 percent to 5.50 percent. The next meeting of the FOMC is July 30-31. What do financial markets think the FOMC will decide at that meeting?

Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk—such as a sudden increase in oil prices or in interest rates—and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banking, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart from the CME’s FedWatch Tool shows the current values from trading of federal funds futures.

The probabilities in the chart reflect investors’ predictions of what the FOMC’s target for the federal funds rate will be after the committee’s July meeting. The chart indicates that investors assign a probability of only 10.3 percent to the FOMC cutting its federal funds rate target by 0.25 percentage point at that meeting and an 89.7 percent probability of the commitee leaving the target unchanged.

In contrast, the following figure shows that investors expect that the FOMC will cut its federal funds rate at the meeting scheduled for September 17-18. Investors assign a 57.9 percent probability of a 0.25 percentage point cut and a 6.2 percent probability of a 0.50 percentage point cut. The committee deciding to leave the target unchanged at 5.25 percent to 5.50 percent is assigned a probability of only 35.9 percent.

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.

Image generated by ChatGTP-4o.

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.