Why revisions in inflation measures impact ETF investors

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Headline PCE are better at forecasting inflation, Mester says

Dr. Loretta Mester spoke about monetary policy and inflation at the Cleveland Fed’s inaugural conference on inflation on May 30. In her speech titled “Inflation and Monetary Policy: Six Research Questions,” Mester focused on the economic importance of price stability and how different measures of inflation can reveal varying price trends. She posed six questions to the audience, urging researchers to make advances in inflation forecasting models based on these questions. In this part of the series, we’ll discuss Mester’s views on the second research question posed to the audience: how should monetary policy makers incorporate revisions to PCE inflation into their policymaking framework?

Using core inflation as opposed to headline inflation

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Certain goods included in both the PCE and CPI are prone to more volatility than others. The most volatile components are thought to be food and energy prices. As these goods can skew inflation numbers and distort comparisons, many economists prefer to exclude food and energy prices to get a sense of inflationary trends in the economy. Inflation that excludes food and energy prices is called “core inflation,” while inflation that includes these prices is termed “headline inflation.” Mester prefers to use headline PCE inflation, as she believes it’s a better indicator of future PCE inflation.

Inflation measures used by the Cleveland Fed

Mester says the prices of certain goods, like apparel, tend to be even more volatile than food and energy prices. In order to enable comparisons, economists at the Cleveland Fed compute inflation measures by excluding a percentage of the most volatile components, whichever category of goods they happen to come from.

Dealing with revisions to the PCE

One of the advantages of the PCE is that it reflects individuals’ current consumption patterns and is revised every month. This means that certain goods that were present in arriving at previous readings of the PCE may be excluded from future computations. This can happen for various reasons, such as consumers preferring a cheaper variant of the same product or a substitution due to changes in technology.

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Mester asked her second research question on the same issue: how should monetary policy makers incorporate revisions to PCE inflation into their policymaking framework? Mester feels there should be more research into revisions in the PCE and monetary policy responsiveness in the face of these revisions.

According to Mester, “Policymakers need to set monetary policy in real time knowing that their policy affects the economy with a lag and knowing that their targeted inflation measure is subject to revision. The revisions are beneficial because they reflect new data that yield a more accurate measure of inflation. But the revisions also pose a challenge to setting monetary policy… Better understanding the magnitude and pattern of these revisions could help inform policymakers about how best to respond to changes in measured inflation rates.”

In the next part of this series, we’ll discuss the third research question she posed to the audience, concerning alternatives to the Fed’s preferred inflation measure, headline PCE inflation. We’ll also discuss how inflation expectations can impact the required rates of return on both stocks (SPY) and fixed income (BND) securities. Inflation expectations are also priced into the U.S. Treasury (TLT) yield curve, affecting yields on both investment-grade (LQD) and high-yield (JNK) debt.

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