Is inflation too low? Depends how you look at it

Conor Sen

Those who argue that the U.S. Federal Reserve should keep interest rates low typically point to the same piece of evidence: The central bank’s preferred measure of inflation remains below its 2 percent target, suggesting that the economy still needs stimulus.
What they ignore is that during the dot-com and housing booms of the 1990s and 2000s, this logic would have led to bigger bubbles — and bigger busts.
The case for or against further stimulus depends a lot on how you measure inflation. The Fed tends to focus on the Commerce Department’s price index for personal consumption expenditures — and specifically on the “core” version, which excludes volatile food and energy prices.
The PCE index differs from the Labor Department’s better-known Consumer Price Index in a number of significant ways. For one, it adjusts more frequently for people’s spending patterns — so if turkey gets expensive and people buy more chicken, it might pick that up. It also covers the full cost of services such as medical care, including the part paid by an employer or insurance company. The CPI, by contrast, covers only out-of-pocket expenditures.
The differences mean that the CPI puts greater weight on areas such as housing and transportation, while the PCE puts more emphasis on health care. Housing costs have been rising at a fast pace and medical care costs have been decelerating, so core CPI has shown higher inflation than core PCE. As of June, the former was up 2.3 percent from a year earlier. The latter was up just 1.6 percent.
So which number matters most for the Fed? That’s debatable. Fed officials, for example, care a lot about what will happen to people’s inflation expectations. To that end, an index that includes a lot of expenses that people don’t see might be less than ideal. If insurance companies and doctors negotiate price changes of which people are completely unaware, how will that change perceptions of inflation?
More important, core PCE has been below the Fed’s 2-percent target for much of the past 20 years, including at times when — in hindsight — it’s pretty clear that raising rates was the right thing to do (see chart below). When the dot-com bubble was raging in December 1999, core PCE was up just 1.2 percent from a year earlier. And in the summer of 2005, when subprime mortgages and credit derivatives were booming, core PCE was at 1.9 percent.
The bursting of the subprime bubble was particularly disastrous, forcing the Fed and Congress to take extraordinary measures to keep the financial system afloat and contain the economic damage. One can only wonder how much worse the episode would have been — and whether Congress would have found the political will to pay for even bigger bailouts — if the Fed had further fueled the boom by conducting even looser monetary policy. We should be glad the bubble got no bigger than it did.
Of course the Fed has to focus on inflation in making its monetary policy decisions. But officials should keep in mind that core PCE is not the only measure, and factor in other indicators such as employment and the behavior of asset markets. If they do so, the case for removing stimulus in the near future will look a lot stronger.
Conor Sen is a portfolio manager for New River Investments in Atlanta. He previously was director for markets and analytics at Kabbage Inc