PCE

The “Lost World” of 2% Inflation

Scott BuchananLeave a comment

Here is a chart of the Core Personal Consumer Index for inflation (Core PCE), which is the Fed’s favorite measure on inflation, from 1970 through early 2024:

This chart is from an article by the Richmond Fed, The Origins of the 2 Percent Inflation Target. That article has a long discussion of how and why the Fed decided to name an explicit inflation target of 2% in 2012. Although controlling inflation has been formally part of the Fed’s “dual mandate” since the Federal Reserve Reform Act of 1977, it had traditionally not set a single numerical target. After years of discussions within the Fed, it was decided that the benefits of a clear single target outweighed the potential downsides. 2% was though to be about the lowest you could run, while still giving the Fed some room to cut short term rates in a recession without running up against the dreaded zero lower bound. It was understood that 2% was a loose target, with some years a little over or under to be allowed to balance each other out.

That Richmond Fed article was published in early 2024. At that point, inflation was falling quickly and steadily from its post-Covid high, as consumers finished spending down their gigantic stimulus package windfalls.

Unsurprisingly, this article concludes that “Even during this period, long-run inflation expectations have remained anchored, rising no higher than 2.5 percent, according to the Cleveland Fed.”

That was about 18 months ago. The actual path of inflation since then has not be a descent to 2-2.5%. Between gigantic peacetime deficits by two administrations, and the results of tariffs, inflation seems to have leveled out at around 3%:

Source

The sub-2% inflation that was normal for twenty years (2000-2020) may now be a lost world.   This puts the Fed in an awkward spot. Even ignoring the irresponsible squawking from some quarters of the government, it will not be an easy decision to keep cutting rates (to address soft employment) if inflation stays this high. The Fed’s mantra this time around is that the current inflation is just a transient response to tariffs and so can be largely discounted. But I recall similar verbiage in 2021, as the Fed dismissed the ramping inflation back then as merely a transitory effect of pandemic supply chain restrictions. They were wrong then, and I suspect it would be wrong now to be too complacent. The 1970s-80’s showed that once the inflation genie gets out of the bottle, it can be very costly to subdue it. Whether 2.0 % is still the right target, however, may be open to debate.

Services, and Goods, and Software (Oh My!)

Zachary BartschLeave a comment

When I was in high school I remember talking about video game consumption. Yes, an Xbox was more than two hundred dollars, but one could enjoy the next hour of that video game play at a cost of almost zero. Video games lowered the marginal cost and increased the marginal utility of what is measured as leisure. Similarly, the 20th century was the time of mass production. Labor-saving devices and a deluge of goods pervaded. Remember servants? That’s a pre-20th century technology. Domestic work in another person’s house was very popular in the 1800s. Less so as the 20th century progressed. Now we devices that save on both labor and physical resources. Software helps us surpass the historical limits of moving physical objects in the real world.


There’s something that I think about a lot and I’ve been thinking about it for 20 years. It’s simple and not comprehensive, but I still think that it makes sense.

  • Labor is highly regulated and costly.
  • Physical capital is less regulated than labor.
  • Software and writing more generally is less regulated than physical capital.


I think that just about anyone would agree with the above. Labor is regulated by health and safety standards, “human resource” concerns, legal compliance and preemption, environmental impact, and transportation infrastructure, etc. It’s expensive to employ someone, and it’s especially expensive to have them employ their physical labor.

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Not Just Consumer Prices

Zachary BartschLeave a comment

We all know about inflation. One popular measure is the Consumer Price Index (CPI), which measures the change in price of a fixed basket of goods. The other popular measure used for inflation is the Personal Consumption Expenditures (PCE) price index. This index measures the price of what consumers actually purchase and captures the effects of consumers changing their consumption bundles over time. While the latter is a better measure for the prices at which consumers make purchases, it takes longer to calculate. In practice, the earlier CPI release gives a pretty accurate preview to the PCE price index.

While consumption is a substantial two-thirds of total expenditures in the US economy, other prices definitely matter. On average, a third of our income is spent on other things. Below is a stacked bar chart of quarterly GDP components – the classic Y=C+I+G+NX.* Investment spending composes a relatively stable 16.7% and Government spending composes about 16.5% of GDP. We almost never hear much about the price of these other things.

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The Time it Took for Price to Rise

Zachary Bartsch1 Comment

Last month, Jeremy wrote about how long it takes for prices to double. He identified a few intervals of time that are sensible. But I want to pick up the ball and move it further down the field. Not only can we identify how long it took for prices to double in particular eras, we can also do it for *every month*. Below, is a graph that shows us how many years had passed since prices were half as high (PCE Chained Prices).

Expectedly, the minimum time to double consumer prices was in the early 80s, taking just under 9 years for price to double. The prior decade included the highest inflation rates in the past 70 years.  Since that time, the number of years needed in order for prices to double steadily rose as the average inflation rate fell. That is, until after the pandemic stimuli which caused the time to plateau. But to be clear, that must mean that prices aren’t doubling any fast that they used to, despite what we’ve heard on the news.

Except… prices are in fact rising faster by 21st century standards. Indeed, measuring the time that it took prices to double covers up a lot of variation. After all, The PCEPI was 15.19 in 1959 and is 122.3 now. That’s only enough difference for three doublings. But as we lower the threshold for price changes, we can see more of the price level patterns. Below-left is the time that was necessary for prices to increase by 50% and below-right is the time that was necessary for prices to rise by 25%.

In these graphs we can see more of the action that happened post-Covid. The time needed for prices to rise by 50% has fallen by about five years since 2020. That’s a 20% shorter time necessary for a 50% increase in prices. The time needed for a 25% increase in prices is even more drastic. As of 2020, people were accustomed to experiencing upwards of 14 years before overall prices rose by 25%. That number fell below 8 years by 2024.

And finally, the most unnerving graph of all is below: the time that was needed for prices to rise by 10%.

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Why Have Economists Continually Underestimated Projected Inflation?

Scott Buchanan5 Comments

I keep reading about how inflation has peaked (even peaked many months ago) and so any minute now the Fed will relent on raising interest rates, and will in fact start reducing them. Every data point that seems to support an early Fed pivot and a gentle “soft landing” for the economy is greeted with optimistic verbiage and a rip higher in stocks.

Except – – other meaningful data points regularly appear which show that inflation (especially core inflation) is remaining stubbornly high. The Personal Consumption Expenditures (PCE) Index is the Fed’s preferred way to track core inflation. It did peak in early 2022, and is falling, but very slowly and fitfully. Just when it seems like it is about to cascade downward, along comes another uptick.  The latest report for 02/24/23 showed the PCE index (excluding the volatile categories of food and energy) increasing 0.6 percent during the month of January, which translated to a 4.7 percent year-on-year gain. That was considerably higher than the 0.4 percent monthly gain (4.3 percent year-on-year) that economists expected.

Source: MV Financial

The chart below illustrates the chronic tendency of the economists at the Fed to lowball the estimates of future inflation. Each of the ten bars depicts quarterly projections of what inflation would be for 2023, starting back in September 2020 (first, green bar).  No one in the craziness of 2020 could be held particularly responsible back then for accurately projecting 2023 conditions. But the Fed embarrassed themselves badly into late 2021 by airily dismissing inflation as “transitory”, due mainly to supply chain constraints that would quickly pass. (See towards the middle of the chart, yellow Sept 2021 and blue Dec 2021 bars projecting a mere 2.2% inflation for 2023.)

Source: Jeremy LaKosh

Only as of December 2022 did estimates of inflation jump up to 3.1% for 2023, and that estimate will surely get revised upward even further.

Many factors probably went into this systematic failure on the part of the Fed economists. There are probably political reasons for erring on the rosy optimistic side, which I will not speculate on here.

One factor in particular was mentioned in the Minutes of the Jan 31/Feb 1 Fed meeting that I thought was significant:

A few participants remarked that some business contacts appeared keen to retain workers even in the face of slowing demand for output because of their recent experiences of labor shortages and hiring challenges.

Jeremy LaKosh notes regarding this feature, “If true across the economy, the idea of keeping employees for fear of facing the labor force shortage would represent a fundamental shift in the employment market. This shift would make it harder for wage increases to mitigate towards historical norms and keep upward pressure on prices.”

This all rings true to my anecdotal observations. In bygone days, when business slowed down, factories would lay off or furlough workers, with the expectation on all sides that they would call the workers back (and the workers would come back) when conditions improved. However, employers have had to struggle so hard this past year to find willing/able workers, that employers are loath to let them go, lest they never get them back. I have read that even though homebuilders are not sure they can sell the houses they are building, they are so worried about losing workers that they are keeping them on the payroll, building away.

Other inflation data points show big decreases in prices for goods (and energy), but not for services. Wages, of course, are the big driver for service costs.

So the inflation story in 2023 seems to come down largely to a labor shortage. This is a large topic cannot be fully addressed here. I will mention one factor for which I have anecdotal support, that the enormous benefits (stimulus money plus enhanced unemployment) paid out during 2020-2021 set up a large number of baby boomers to leave the workforce early and permanently. Studies show that this is a major factor in the drop in workforce participation rate post-Covid. Maybe some of those folks had not planned ahead of time for such early retirement, but they got a taste of the good life (NOT getting up and going to work every day) in 2020-2021 along with the extra cash to pad their savings, and so they decided to just not return to work. That exodus of trained and presumably productive workers has left a hole in the labor force which now manifests as a labor shortage, which drives up wages and therefore inflation and therefore interest rates, which will eventually crater the economy enough that struggling firms will finally lay off enough workers to mitigate wage gains.

I wonder if this unhappy scenario could be staved off with increased legal migration of targeted skilled workers from other countries to alleviate the labor shortage. Dunno, just a thought.

Inflation, Information, & Logic

Zachary BartschLeave a comment

Most economists know that the CPI is overestimated and therefore prefer the PCE price index. However, monthly CPI data is consistently released before PCE data for a given month. One would think that they move in the same direction and be highly correlated. Indeed, in the past five years, the correlation is 0.96. Therefore, it stands to reason that the there is less new relevant information on the PCE release dates than on the CPI release dates. Yes, CPI is biased, but it still contains some information about prices and it is known well prior to the more accurate PCE numbers.

Supply and Demand react to new information. Sometimes the new information changes our expectations about the future, and other times we learn that our beliefs about goods and assets were previously not quite right. So, with new relevant information comes new prices as people update their beliefs and expectations.

Let’s get financial.

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Inflation Empirics

Zachary Bartsch2 Comments

Way back in the late 1970s and early 80s, Kydland and Prescott proposed rational expectations theory. This line of research arose, in part, because the Phillips curve ceased to describe reality well. Amid increasing inflation, people began to anticipate higher prices to a relatively correct degree when making labor, supply chain, and pricing decisions. Kydland and Prescott argued that individuals understand the rules of the game or how the world works – at least on average.

An increase in the money supply would increase total national spending, and increase demand for goods. However, firms also experienced increasing revenues and demanded more inputs such as commodities, capital, and intermediate goods. Because there were no greater productivity earlier in the supply chain, price roses. Firms began to understand that greater demand would eventually find its way to causing greater costs. Therefore, firms began raising prices before the cost of resources rose, increasing their willingness to pay for inputs and, ironically, hastening the increase in input prices. As a result, increases in the money supply began having substantial short-run price effects and negligible output effects.

However, assuming that people understand the rules of our economic system and ‘how the world works’ is hard to swallow. It is not at all clear that the typical economist understands monetary theory, much less clear that the typical person has a good understanding. Fortunately, another theory of expectations can help carry some of the load and achieve similar results.

Adaptive Expectations

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