When the Federal Reserve refers to inflation, it is talking about the rate of change in PCE inflation (or the price index for personal consumption expenditures). According to the central bank, this indicator is the “most consistent over the longer run with the US Federal Reserve’s statutory mandate.” The Fed is expected to maintain PCE inflation at 2% in the longer run.
The graph below shows the primary reason behind the Federal Reserve not having been able to raise the federal funds rate for the past several months. The PCE inflation rate is not even close to the mandated 2% level. Further, both PCE inflation, and core-PCE inflation, which does not consider price changes in energy and food products, have fallen.
The Fed revised down its projections for PCE inflation compared to its earlier projections. A fall in energy prices, especially crude oil, has put immense pressure on companies like Kinder Morgan (KMI), Chevron (CVX), and ConocoPhillips (COP). The fall in prices has been the primary deterrent in the rise in PCE inflation.
However, a fall in import prices has ensured that core-PCE inflation will also remain under check. The Fed anticipated that the dollar appreciation and lower commodity prices would put downward pressure on non-oil import prices.
FOMC participants’ outlook
Several FOMC (Federal Open Market Committee) participants thought that the risks to inflation “tilted to the downside.” This is to say that they feel inflation could move further down. They were of the view that the recent global developments could push down PCE inflation further in the near term. However, in the medium term, they expected inflation to get back to the expected trajectory towards 2%.
Investors in fixed income ETFs like the PIMCO Total Return – A (PTTAX) and the American Century Diversified Bond – A (ADFAX) should track the movement in inflation expectations closely. An unexpected rise in the near term may result in an earlier-than-anticipated hike in the federal funds rate, which could potentially impact fixed income investments.
In the next article, we’ll see what the September 2015 minutes had to say about the US labor market status.