When the Federal Reserve refers to inflation, it is talking about the rate of change in PCE inflation. This is the price index for personal consumption expenditures (or PCE). According to the central bank, this indicator is the “most consistent over the longer run with the US Federal Reserve’s statutory mandate.” Further, the Federal Reserve has a specified numerical mandate for PCE inflation given to it by Congress. The central bank is expected to maintain PCE inflation at 2% in the long run.
A look at the graph below illustrates the primary reason behind the Fed not being able to raise the federal funds rate for the past several months. The rate of PCE inflation is not even close to the mandated 2% level.
Both PCE inflation and core PCE inflation, which does not consider a change in prices of energy and food products, have fallen. In its latest reading, PCE inflation for September 2015 rose by just 0.2%, half the pace set a month ago. Core PCE inflation rose by 1.3%, slightly faster than the previous month’s pace.
The last man standing?
The Federal Reserve has made it clear that it will remain data-driven as far as a rate hike is concerned. If the underlying data does not support the case for a rate hike, the policymakers will not effect one. However, with the economy doing well—driven by consumer spending and job additions looking strong—could PCE solely ensure that a rate hike does not take place in December?
As of now, it seems difficult, but not impossible—especially if we assume that the amount of the rate hike could be low. Increased consumer spending should show up in the inflation numbers soon. All the Fed needs is to see PCE inflation moving toward 2%, even if it does not reach that figure. Given that the fall in energy prices is transitory, a rebound could be good not only for energy companies like Kinder Morgan (KMI), Chevron Corporation (CVX), and ConocoPhillips (COP), but also for inflation.
Investors in fixed income mutual funds like the PIMCO Total Return (PTTAX) and the American Century Diversified Bond (ADFAX) should track the movement in PCE inflation and inflation expectations closely. An unexpected rise in the near term could result in an earlier-than-anticipated hike in the federal funds rate, which could potentially impact their fixed income investments.
In the next article of this series, let’s look at what the Fed could do in December.