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By HaleStewart September 13, 2017 12:25 pm
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US Bond Market Week in Review: There is an Inherent Weakness in the PCE Price Deflator That the Fed Isn't Considering

            For most of this expansion, the Fed has publicly stated that it is using a 2% inflation target.  In addition, their models have continually had a “just around the corner” feature, where, despite currently weak PCE measures, higher inflation would occur in the near future.

            Unfortunately, a historical look at the broad components of their preferred inflation measure belies the Fed’s optimistic projections:

Above is a logarithmic graph of the three components of the PCE price index: durable goods prices (in blue), non-durable goods prices (in red) and service prices (in green).  Two key visual elements are apparent: durable goods prices have been consistently declining since the mid-1990s.  Nondurable goods prices have been stagnant to slightly lower for the last 5 years.  That leaves services as the only PCE price index component that can exert upward pressure. 

            Let’s look at the same data from a Y/Y percentage change perspective:

Durable goods prices (in blue) have been subtracting from price growth for the last 20 years.  Nondurable goods prices (in red) have been declining since 2011-2012; they subtracted from PCE price growth for most of 2015 and only recently turned positive.  Only service prices (in green) have increased PCE price pressures on a consistent basis.

            There are several important lessons to draw from this data.   First, the PCE price index looks at prices from a business perspective.  According to the Cleveland Fed, “the PCE is based on surveys of what businesses are selling.”  The above charts indicate that neither durable goods nor non-durable goods companies have any pricing power.  Second, the Y/Y percentage change in service prices has been declining.  Third, price growth for 31% of PCEs are either negative or very weak.  That means the remaining 70% of prices would have to increase at a faster Y/Y rate to hit the Fed’s 2% PCE Y/Y inflation target.  This runs counter to the second conclusion regarding service prices.

            Based on the above data, it’s literally impossible for the Fed to hit its 2% Y/Y PCE price target.    


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