Why Could Watching Inflation in 2016 Be Important?



What is PCE inflation?

The level of price rise, or inflation, has several measures, the more popular ones being the CPI (consumer price index) and the PPI (producer price index).

Policymakers at the Federal Reserve use a separate measure of inflation called 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.”

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Why does it have a bearing on monetary policy?

The rise in inflation in an economy, apart from other things, dictates consumption patterns. A surge in prices will deter consumers from consuming more. This is not to say that low inflation, or deflation, is a good thing, because reflation is indicative of a receding economy.

By making use of monetary policy tools such as changes in key rates and open market operations, a central bank guides inflation to its preferred path by changing the money supply in the financial system. There is no set value or preferred pace of inflation. It differs depending on the state and development phase of the economy.

The US Federal Reserve is mandated by Congress to maintain the level of PCE inflation at 2% in the long-term. However, as seen in the above graph, the indicator has been below this level for quite some time. A fall in crude oil prices beginning mid-2014 not only impacted energy companies around the world such as Royal Dutch Shell (RDS.B), TOTAL (TOT), and Statoil (STO), but was also the primary reason PCE inflation tanked, as reflected in the graph.

Why you should monitor inflation

While announcing the rate hike, the central bank said that inflation would be its focus as far as future rate hikes are concerned. For fixed-income investors (PONAX) (PDINX), the pace of PCE inflation’s rise will provide hints regarding the number of rate hikes to expect for 2016. This will help to guide their portfolio positioning.

A surge in inflation would likely require movement to shorter-duration securities and mutual funds as well as investment into inflation-protected instruments.

In the last article of the series, let’s discuss some final thoughts on fixed-income investing for 2016.


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