MNI POLICY: Softer Trend Inflation Boosts Case For Fed Pause

U.S. underlying inflation could be softer than official readings suggest, indicating the recent reduction of prices pressures is likely to persist and the Federal Reserve can achieve its mission of bringing inflation back to its 2% target over time without more interest rate increases.

Fed officials arguing the central bank should stop raising interest rates are taking heart in the New York Fed's new Multivariate Core Trend inflation measure, which has declined for seven straight months to 2.76% in July. By comparison, the standard twelve-month headline PCE measure stood at 3.3% in July, while core PCE, seen by Fed officials as a better proxy for the underlying trend, was higher at 4.2%.

An MCT reading below core PCE suggests a substantial part of core PCE is transitory while another significant portion reflects past inertia. Assuming there is no shock in the near future, core PCE could be expected to eventually converge with the MCT measure, which is already closer to the Fed's 2% inflation goal.

For the moment, officials are encouraged and expect further reductions in underlying price pressures, although that road will likely remain bumpy -- as shown by this week's stronger-than-expected CPI print.

HIGHER LEVELS, SAME TREND

Key trimmed PCE measures from other regional Fed banks paint a similarly encouraging picture. The Dallas Fed's 12-month Trimmed Mean PCE inflation rate is at 4.1%, but has fallen for three straight months from 4.8% in April. The Cleveland Fed's Median PCE Inflation rate has posted four straight monthly declines, sliding to 4.8% in July from 5.9% in March.

Those gauges omit outlying changes and focus on the interior of the price distribution -- hence the term "trimmed" -- while the MCT goes a step further using a dynamic factor model with time-varying parameters allowing for the common component to change over time.

The MCT measure decomposes each sector’s inflation as the sum of a common trend, a sector-specific trend, a common transitory shock, and a sector-specific transitory shock, and the trend in PCE inflation is constructed as the sum of the common and the sector-specific trends weighted by the expenditure shares.

Since January 2023, the MCT measure of inflation persistence has been on a steep decline, down by half from 5.54% at the peak in June last year. The sectoral decomposition shows the declining trend was initially due to weaker core goods and services ex-housing inflation.

One lesson from the measure of inflation is that during episodes of high inflation prices are driven mostly by a common component, not an individual sector. A second is that those high-inflation periods produce more unpredictable and volatile inflation.

More recently, core goods has made a slightly negative contribution, while services ex-housing is proving more persistent. A large part of the stubbornness in core goods, housing, and services ex-housing inflation is explained by the sector-specific component. The common component has declined considerably in the last few months.

Atlanta Fed President Raphael Bostic argued in a speech last month that, excluding the upward push on prices from housing that policymakers expect to wane with a lag in line with the values of new rental leases, "a case could be made that... underlying inflation may well be close to our target already."

The Fed is largely expected to hold off from raising rates again next week, despite an above-expected core CPI gain of 0.3% in August. (See: MNI INTERVIEW: Hawkish Fed Pause In Sept - Ex-Staffer Trezzi)