Revisiting the PCE Inflation Report

Eakinomics: Revisiting the PCE Inflation Report

This past Friday the Bureau of Economic Analysis released February data on the price index for Personal Consumption Expenditures (PCE). The PCE price index is the Federal Reserve’s preferred measure of inflation because it reflects the actual mix of goods and services purchased in the economy (as opposed to the fixed basket of goods and services in the Consumer Price Index). Overall, the PCE price index rose at an annualized rate of 3.2 percent in February, and it rose 5.0 percent from February 2022 – down from 5.3 percent year-over-year in January.

The data were broadly trumpeted as significant progress in fighting inflation. The New York Times’ headline read “The Fed’s Preferred Inflation Gauge Cooled Notably in February,” while The Washington Post concluded “A key inflation gauge tracked by the Fed slowed in February.” This coverage suggested that the Fed could divert its attention from fighting inflation, with the presumption that stopping rate increases would ease pressure on the banking sector.

But is that the right way to interpret the data? The chart shows two key measures of inflation contained within the PCE report. The first is inflation in the prices of services, shown in blue. Services has been the dominant source of inflation since the start of 2022. While goods-price inflation has shown some dampening, services inflation has been much more stubborn. The February report repeated this pattern, as year-over-year inflation actually rose from 5.6 to 5.7 percent, the highest since the onset of inflation in 2021.

The services inflation problem explains the Fed’s focus on the labor market. Labor is the most important part of the cost of providing services, so wage inflation feeds services-price inflation. Last Friday’s PCE report raises the stakes on this Friday’s employment report showing some slack in the labor market.

The orange line shows core inflation (excluding food and energy) as measured by actual market transactions (with no imputed data). The market-based core is a good indicator of the underlying trends in inflation. It does show some success, as it is down to 4.7 percent year-over-year after reaching 5.4 percent recently. But 4.7 percent is a long way from the 2 percent target and progress has been slow as it fell only 0.1 percentage points in the past month.

To my eye, there is nothing in these data that would allow the Fed to declare victory. Monetary policy will have to continue to become more restrictive and will do so. But the Fed clearly believes it can stave off any liquidity pressures on the banking system through the use of discount window lending and its new Bank Term Funding Program.