US PCE Price Index preview: A brief history of inflation targets

• Core PCE prices predicted to be unchanged in July
• Inflation continues under Fed 2% target
• Fed policy is focused on economic growth

The Bureau of Economic Analysis (BEA) a division of the Commerce Department will release the July Personal Consumption Expenditure (PCE) Price Index on Friday August 30^th 12:30 GMT, 8:30 EDT.

Forecast

The core PCE monthly rate is predicted to be stable at 0.2% as is the yearly rate at 1.6%. The overall PCE price increase was 0.1% in June and the annual rate was 1.4%.

The Fed and inflation targets

Since the Federal Reserve adopted an official 2% inflation target for the core personal consumption expenditure (PCE) price index at the January 25^th 2012 FOMC - before there had usually been a range - it has been observed almost exclusively in the breach.  In the 90 months subsequent just 13 or 16% have met the 2% target.

Last year was the first and only year since inception that had a majority, 9 out of 12 months, at or above target. In fact after the first four months of 2012 core PCE inflation did not touch 2% for six years until March 2018.

Reuters

Quantitative easing

The three rounds of quantitative easing initiated by the Fed in November 2008, which lasted at intervals for almost six years, were designed to promote economic growth and assist recovery from the financial crisis. In that they were successful.  

A secondary set of goals was to head off the disinflationary pressures and the threat of deflation in the immediate aftermath of the crisis and to foster inflation. The first two goals were achieved, the third has largely failed.

The Fed inflation response

The Fed’s response to the perennial underperformance of inflation over the past seven years has been rhetorical.

Chairman Powell’s response to a question about low inflation at the May 1^st press conference could stand in for any number of official Fed comments about inflation over the past eight years. “The weak inflation performance in the 1st quarter was not expected...some of it appears to be transitory or idiosyncratic.”

Compare the following two FOMC statements:

“The Committee judges that … [this] target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.”

“This action supports the Committee’s view that sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective are the most likely outcomes…”

The first statement is from the December 2018 meeting when the FOMC raised the fed funds rate 0.25%. The second is from the July 31^st 2019 meeting where the Fed cut the base rate by the same amount.  

Supporting inflation by raising and lowering interest rates is not traditional monetary policy.

Inflation, economic growth and Fed policy

In the decade since the financial crisis the Federal Reserve’s primary concerns were first reviving and ensuring economic growth and second retrieving interest rate policy from its crisis intervention level, inflation has been a distant third.

Reuters

Under Ben Bernanke the bank instituted its quantitative easing policies because the economic response from zero rates was inadequate to counter the debilitating effects of a balance sheet recession.  By Janet Yellen’s term the central bank’s priority was to bring the fed funds rate back to normal levels as quickly as the economy would tolerate. Both policies were successful.  The economy recovered from the worst recession and crisis since the Depression and the wisdom of pushing rates higher from the 0.25% upper target is evident now. The Fed started this round of cuts with the largest rate cushion in the industrial world.

The Fed’s current objective is to keep US economic growth and the benefits of an active labor market on track. The rate reductions, assuming the FOMC will cut in September, are an insurance policy against the global and domestic threats of the continued trade war with China and the impact of an abrupt exit of Britain from the European Union.

Put it another way, if the trade dispute and Brexit were settled tomorrow would the Fed governors pursue lower rates?  Continuing the logic a step further would the decline of core inflation from 2.1% in July 2018 to 1.6% a year later, absent other problems, prompt a 50 basis point fed funds cut?

Judging from Fed policy over the last ten years the answer is no.  

Inflation has become a rhetorical adjunct to more important policy goals. If PCE is weaker than predicted in July, it will be a quoted as a support for lower rates. If it is stronger than expected Mr. Powell may call it transitory and note that symmetric covers both sides of the 2% target.