Is Inflation Really as Low as the Fed Fears?
|Executive Summary
Fed officials have been concerned about inflation’s ongoing shortfall from the FOMC’s 2% target. Core PCE inflation has averaged only 1.6% over the current expansion, and has weakened more recently. The undershoot and handwringing over the miss come as a surprise to many of the clients to whom we speak, who feel their own costs have been rising more rapidly.
The perception that inflation is higher than official figures comes as prices for many items are indeed rising faster than 2% and have picked up more recently. Of course other items offset these gains, but often garner less attention. Moreover, a number of statistical practices, like quality adjustment, depress inflation readings relative to transaction prices, although other practices may overstate inflation. These methods have been little changed in recent years, however, meaning that they are unlikely to bias inflation today relative to previous periods.
While inflation has picked up for many items over the past couple of years, it still remains low compared to the prior expansion. The upshot is that real household income and spending continue to benefit from low inflation, while monetary policy has no glaring need to become restrictive.
Wide-Ranging Perspectives
As far as the Fed is concerned, inflation is largely absent. In March, the core PCE deflator slipped to 1.6%, year-over-year. While recent weakness may have been exaggerated by a number of temporary factors, there is no getting around the fact that inflation has struggled to reach the FOMC’s target for the vast majority of the expansion. In the 10 years since the recession, both headline and core PCE inflation have increased at an average annualized rate of 1.6% compared to the FOMC’s 2.0% goal. The prolonged shortfall has generated a rethink of the underlying drivers of inflation and the Fed’s approach to its price-stability mandate.1 More immediately, it has spurred debate about the FOMC cutting the fed funds rate this year to support inflation.
The handwringing about low inflation may seem odd to businesses and households at the moment. Businesses have seen their own costs pick up over the past few years, especially for labor. At the same time, “low” inflation in the official sense may not jibe with consumers’ views when seeing prices pick up for everyday items, or the sticker-shock from less frequent purchases that have been outstripping broader inflation for years, like college education or a hospital stay.
The reality is that the low rate of headline or core inflation masks wide variance in price changes. Declining prices for some goods and services are offsetting price hikes elsewhere. Figure 3 illustrates the spectrum of inflation across goods and services.2 We show the two-year annualized inflation rate in order to filter through some of the short-term noise that inevitably comes from surveys. While overall prices rose at a 1.8% pace over this period, that does not capture everyone’s experience or perception of inflation.
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