US Bond Market Week In Review: There Is An Inherent Weakness In The PCE Price Deflator That The Fed Isn't Considering
For most of this expansion, the Fed has publicly stated that it is using a 2% inflation target. In addition, their models have continually had a “just around the corner” feature, where, despite currently weak PCE measures, higher inflation would occur in the near future.
Unfortunately, a historical look at the broad components of their preferred inflation measure belies the Fed’s optimistic projections:
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Above is a logarithmic graph of the three components of the PCE price index: durable goods prices (in blue), non-durable goods prices (in red) and service prices (in green). Two key visual elements are apparent: durable goods prices have been consistently declining since the mid-1990s. Non-durable goods prices have been stagnant to slightly lower for the last 5 years. That leaves services as the only PCE price index component that can exert upward pressure.
Let’s look at the same data from a Y/Y percentage change perspective:
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Durable goods prices (in blue) have been subtracting from price growth for the last 20 years. Non-durable goods prices (in red) have been declining since 2011-2012; they subtracted from PCE price growth for most of 2015 and only recently turned positive. Only service prices (in green) have increased PCE price pressures on a consistent basis.
There are several important lessons to draw from this data. First, the PCE price index looks at prices from a business perspective. According to the Cleveland Fed, “the PCE is based on surveys of what businesses are selling. ”The above charts indicate that neither durable goods nor non-durable goods companies have any pricing power. Second, the Y/Y percentage change in service prices has been declining. Third, price growth for 31% of PCEs are either negative or very weak. That means the remaining 70% of prices would have to increase at a faster Y/Y rate to hit the Fed’s 2% PCE Y/Y inflation target. This runs counter to the second conclusion regarding service prices.
Based on the above data, it’s literally impossible for the Fed to hit its 2% Y/Y PCE price target.
Disclosure: None.