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Is Inflation Frozen Too? Should the Fed Let It Go?

At the end of 2019, Frozen II was released to the delight of children who had been counting down the days since the release of the original film in 2013. Their yearning for a sequel may only be surpassed by central banks’ desire for a resurgence in inflation. If the economy has been expanding for a decade, why isn’t inflation higher?

The reason to ponder the dog that didn’t bark is that inflation has significant impacts to fixed income markets both through implications directly to rates as well as for monetary policy. In discussing the Fed’s three rate cuts in 2019 at his December 2019 press conference, Chairman Powell stated that “inflation pressures were unexpectedly muted, strengthening the case for a more supportive stance of policy.”

Today’s inflation levels are a far cry from the 1970s when President Gerald Ford declared inflation “public enemy number one” or even from the 2008 financial crisis when deflation was the fear du jour. Yet, inflation seemingly persistently and stubbornly below targeted levels has perplexed and challenged markets. What unexplored factors could be influencing this outcome? Does inflation remain Frozen too? Should the Fed Let it Go?

Some things never change

The Fed’s dual mandate was established in 1977 and one of those two mandates was ‘price stability.’ It is important to recall the significance of inflation at that time. Official measures showed inflation above 12% in 1970s, but inflation was palpable without a government tracker. It even extended into popular culture, for example when ‘All in the Family’ aired a four-part episode titled, “The Bunkers and Inflation.”

Tapping into this zeitgeist, President Ford delivered a speech entitled, “Whip Inflation Now” in 1974 and WIN buttons became common (if derided) attire. In his memoir, Ford’s Chairman of the Council of Economic Advisors described WIN as “unbelievably stupid” though publicly supporting it at the time. That Chairman would later go on to be Chairman of the Federal Reserve. In this later role, Alan Greenspan described ‘price stability’ as “that state in which expected changes in the general price level do not effectively alter business and household decisions.”

In the 1970s, inflation very much impacted business and household decisions. Were Congress to implement a Fed mandate today in contrast to the environment of the 1970s, the discussion around ‘price stability’ would be very different.

Into the unknown

The Fed has referred to inflation as ‘below target,’ but this begs an interesting question: how do you measure inflation? The two most commonly utilized metrics are Consumer Price Index (CPI) and Personal Consumption Expenditure (PCE), though many others exist. Even within those, variants differentiate between headline and core (excludes food and energy) as well as more subtle distinctions (standard calculation versus trimmed mean, all urban consumers versus urban wage earners and clerical workers), etc. Inflation may be a critical measure, but it is not a uniform one.

Different component weights within CPI and PCE as well as different methods in calculation have naturally led to different results in measuring inflation over time. For example, Core CPI has been approximately 60 basis points higher on average over the past 50 years than Core PCE (+4.0% vs. +3.4%, respectively).

ComponentCPI weight (%)PCE weight (%)Difference (%)
Food and beverages15.012.92.1
Medical care8.422.0-13.6
Education and communication7.16.20.9
Other goods and services3.213.4-10.2

Source: Bureau of Economic Analysis 2015

Differences in the measurement may have been larger in absolute terms in the past, but when all measures of inflation were elevated, a broad consensus existed to combat it. Today, as core CPI and core PCE straddle the 2% target, the implications between one metric and the other could have profound policy implications. Were the Fed to focus on Core CPI, would it have felt as comfortable cutting rates in 2019?

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Originally Posted in February 2020 – Is Inflation Frozen Too? Should the Fed Let It Go?


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