Thursday, January 30, 2014

PCE inflation rate lowest since 2009 - key to future Fed policy

Economic indicators continue to point the Fed staying the course with the policy of "small taper" (see post) - a gradual reduction in securities purchases. Behind all the noisy economic data over the past month, one key measure is telling the central bank to remain cautious. The Fed's preferred inflation measure, the so-called PCE price index has grown less than 1% over the past year (chart below) - the lowest quarterly growth in inflation since 2009. At this rate of price increases, many economists refer to the current situation as "disinflationary".

PCE Price Index YoY

To be sure, there is more to this story than weakness in US inflation. It is important to point out that we are seeing quite a divergence between key components of the PCE index. Growth in the cost of services declined after the financial crisis but stabilized at around 2% per year more recently - which where the Fed wants to see the overall index. On the other hand, prices for durable goods in the US peaked in the mid-90s and have since been undergoing a secular decline (chart below), becoming a major detractor from the overall inflation index growth. Furthermore, price declines on durable goods have accelerated somewhat over the past quarter.

PCE Price Index (level): blue = Durable Goods, red = Services

One specific item worth pointing out is the growth in healthcare costs. When people think of rising prices on services, they often point to healthcare. While healthcare costs have historically grown much faster than the overall service sector, that is no longer the case (chart below). Given the massive public (and private) sector future liabilities that are linked to healthcare expenditures (see post), in the long run this trend is absolutely critical for the US.

PCE Price Index (YoY % changes): blue = Healthcare, red = All Services



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