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Energy price stabilization could draw inflation close to target

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Fed’s mandate—price stability

Since 2012, the FOMC (Federal Open Market Committee) held its inflation goal at a 2% annual rate. The Fed’s measure of inflation is based on the change in the price index for personal consumption expenditure, or PCE.

Inflation is one of the Fed’s objectives—as assigned by Congress. The Fed’s dual mandate is balancing inflation with unemployment. It needs to achieve maximum employment and price stability. In order to meet these long-term objectives, the Fed needs to balance the effect of a monetary move on inflation and changes in unemployment.

Over the past 25 years, inflation largely remained stable. It averaged 2.06%—despite the turmoil from the Great Recession. There was also speculation about deflation or inflation. In the short term, inflation can be volatile.

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A decline in energy prices

Over the past year, inflation only averaged 1.2%. The weakness reflects the decline in energy prices. Prior to the fall in energy prices, the 12-month PCE inflation rate was 1.7%. It was still close to the 2% target. At the same time, the Core Price Index’s core PCE inflation only averaged 1.4% in 2014. The Core Price Index excludes the volatile food and energy categories.

The Energy Select Sector SPDR Fund (XLE), the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), the iShares Dow Jones US Energy Sector Index Fund (IYE), the VanEck Vectors Oil Services ETF (OIH), and the First Trust ISE Revere Natural Gas Index Fund (FCG) are examples of ETFs that track energy sector equities in the US.

Bringing inflation up to its target, especially once energy prices are back to their competitive market levels, is still a challenge for the Federal Reserve in the US.

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