Politics & Policy

What Should the Fed Watch?

The CPI versus the PCE, and the imperfect prospects of each.

An article in Monday’s Wall Street Journal indicated that Federal Reserve officials have discussed how to communicate a numerical inflation target to the public. Aside from disparate opinions among Fed board members about what that number should be, the discussion itself centered on a non-monetary price indicator that doesn’t offer much more promise than the already unreliable consumer price index.

 

Specifically, the Fed would target an index of personal consumption expenditures, or the PCE. Both the CPI and PCE measure the average change in the prices of goods and services purchased by consumers. Yet while the CPI tracks direct measures of household spending, the PCE subtracts sales by firms to businesses and governments as a way of isolating consumer purchase prices. The formulas used to calculate each are different, but the end result is much the same in terms of tracking consumer price changes.

 

While PCE measures of inflation occasionally come in lower than the CPI, the former is notable for measuring medical care paid for by employers, along with health care paid for by Medicare and Medicaid. Overall, there is a 4 percent weighting of medical care in the PCE (versus 1.5 percent in the CPI) that on its face could distort supposed inflation calculations. Indeed, due to employer and government-paid health care, there has been a great deal of medical price inflation over the years, the result of patient indifference to health care costs.

 

Though there is much debate about which is the more accurate measure, the Journal article noted that for “years the Fed has preferred the core PCE index, arguing that its composition better reflects consumer spending patterns than does the popular consumer price index.”

 

But prices change all the time for non-monetary reasons, as consumer tastes change. The PCE consumer basket is regularly revised to account for these changes, but according to a Kansas City Fed study, the revisions occur “in the months immediately following the release” date. In short, revisions occur after the fact, and as such, indicate price inflation or deflation that has already occurred.

 

The preferred PCE indicator also will focus on “core” prices, or in other words, the indicator excludes food and energy. This supposed innovation first came about in the 1970s when then-Fed chairman Arthur Burns looked to exclude rising food and energy prices to massage inflation statistics lower. The obvious problem here is that energy, in particular, is a commodity that very quickly registers changes in the value of the currency in which it’s priced. To exclude energy is tantamount to saying that inflation is a non-monetary phenomenon, which means the Fed would be utilizing a very incomplete inflation indicator.

 

It is said that the PCE is better than the CPI at measuring the effects of technological advances on prices, but this supposed advantage raises questions about whether the Fed should seek to monetize market activity at all. Technological advances are neither inflationary nor deflationary, they are merely improvements in how we live, work, and consume. To monetize is once again to distort the ways in which prices organize any market economy.

 

Fed chairman Ben Bernanke has suggested an inflation target of 1 to 2 percent using the core PCE, but according to the Journal article, some Fed officials “believe a 1%-to-2% range is too low.” Well, 2, 3, and 4 percent inflation all seem low in nominal terms, but the price level would double in 36, 24, and 18 years respectively if the Fed were to achieve any of these inflation targets.

 

Importantly, some at the Fed feel the announcement of any numerical target would be problematic since it would give “the Fed little room to make the kind of cuts in inflation-adjusted interest rates that might be needed to remedy severe economic weakness.”  There lies the problem with central bankers who see their role as one that involves “managing” economic growth.

 

If the Fed greatly reduced its mandate, and instead concentrated on dollar price stability against a commodity such as gold, there would then be no need for the Fed to act in times of economic weakness. It has to be remembered that in managing the dollar, the Fed is not creating anything. Instead, it merely expands or decreases our productive capacity depending on how well it achieves currency, as opposed to price, stability.

 

While consumer price inflation can be indicative of currency weakness/inflation, prices are by definition sticky, and only warn of inflation long after it has worked its way into the general economy. As such, any inflation detected by the PCE index would have long past been priced by the markets; meaning the market response to the release of these figures would merely be the market response to how the Fed might react to a lagging indicator.

 

Though it might be utopian to assume the Fed would instead adopt a commodity-price rule to manage the dollar’s value, the latter would be far more effective than management of a price index that would retard the process by which producers respond to consumer wants and needs.

 

– John Tamny is a writer in Washington, D.C. He can be reached at jtamny@yahoo.com.

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