LONDON (Reuters) - U.S. inflation is running well below the Federal Reserve’s informal target of 2%, which will give policymakers political and economic cover if they choose to cut interest rates this week.
Prices for personal consumption expenditures (PCE) rose by just 1.35% in the 12 months to June, according to estimates published by the U.S. Bureau of Economic Analysis on Tuesday.
The core PCE deflator excluding volatile food and energy items as well as government-regulated prices, which is a cleaner measure of inflationary pressure within the economy, was up by just 1.56%.
PCE inflation on both measures has eased significantly over the last year, mirroring the slowdown in the economy since the middle of 2018 (“Personal consumption and outlays”, BEA, July 30).
PCE deflators have long been the Fed’s favourite inflation measures so policymakers could cite them to justify a rate cut when the Federal Open Market Committee concludes its two-day meeting on Wednesday.
But the PCE deflators also reveal the awkward dilemma in which rate-setters find themselves about whether to cut rates, and if so how aggressively, given that the economy is not currently in recession.
The PCE all-items deflator has only been at or above the Fed’s 2.0% target in 29 out of 126 months since the start of 2009.
The core market-based PCE deflator has only reached or exceeded the Fed’s target in 8 out of 126 months since the start of 2009.
So while the PCE deflators have eased significantly since mid-2018 they are not particularly low when judged against the record of the current business cycle.
Moreover, there are some signs PCE inflation hit a low point during the first part of the year and had steadied by June.
Based on PCE inflation alone, it is hard to see why the Fed would ease interest rates at present.
But the deflators also confirm the emergence of a two-speed economy with services performing strongly while manufacturing has stalled. PCE services prices were up 2.24% year on year in June while PCE goods prices fell by 0.58%.
In recent decades, services inflation has generally been steadier and higher, while goods inflation has been lower and more volatile.
The growth of the less-volatile service sector relative to more-volatile manufacturing has helped stabilise the overall economy in terms of output, employment and prices.
But the service sector is still linked to manufacturing and the time series show clear evidence that changes in manufacturing activity and inflation can bleed across into the service economy.
Adjusting for the differences in their absolute level and volatility, PCE goods and services inflation have been closely correlated.
The case for an interest rate cut therefore rests on the need to create a firebreak to prevent the current weakness in manufacturing activity and prices from spilling over into services.
The Fed’s dilemma is how aggressively to cut interest rates this week and in the remainder of the year given the resilience of the service sector and the risk of inflating another bubble like the dotcom bubble of 1999/2000 or the housing bubble of 2006/07.
John Kemp is a Reuters market analyst. The views expressed are his own.
- Twin-speed economy poses dilemma for the Fed (Reuters, July 26)
- Fed will try to create firebreak to contain downturn (Reuters, July 19)
- Fed likely to cut interest rates if U.S. manufacturing continues to slow (Reuters, May 2)
Editing by David Evans