Underlying Price Trends Drop to Multi-Year Lows

The Hidden Numbers

Traditional inflation measures are still showing inflation well above the Federal Reserve's 2% target. A set of alternative indicators points in a different direction.

These gauges are called trimmed-mean measures. They remove the most extreme increases and decreases in prices to reveal the central tendency of most items. To build its gauge, the Dallas Fed starts with the PCE price index, the Fed's primary inflation forecasting tool, then excludes the lowest 24% and highest 31% of price changes.

The Cleveland Fed's version is based on the CPI and takes a 16% trimmed mean, keeping price changes between the 8th and 92nd percentiles. These indicators have drawn criticism that they may also fail to capture the full inflation picture.

The Commerce Department said all-items PCE prices fell 0.1% in June, largely because fuel costs declined, while core PCE prices, which exclude food and energy, rose 0.1%. Compared with a year earlier, the two gauges rose 3.7% and 3.3%, respectively.

Fed officials emphasize that they do not read too much into a single month's reading. Still, the trimmed-mean trend may draw notice given Kevin Warsh's plan to review the Fed's approach to inflation and the indicators it tracks.

The Fed Is Split on What to Do

The Federal Open Market Committee held its benchmark interest rate steady, but three regional presidents dissented. Dallas Fed President Lorie Logan preferred a quarter percentage point increase. Minneapolis Fed President Neel Kashkari and Cleveland Fed President Beth Hammack argued that price pressures are too elevated and that the Fed should tighten without further delay.

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Logan, whose Dallas Fed institution publishes the trimmed-mean gauge, warned against overinterpreting the latest numbers because of compositional effects. Her researchers have found "that a change in the mix of price increases and decreases is causing the trimmed mean to drop too many increases right now. This effect likely makes the trimmed mean lower than the true inflation trend."

She also said: "Even after accounting for productivity gains and temporary supply shocks, inflation appears to be trending toward the mid-2's, not all the way to 2 percent, and the risks are to the upside."

Warsh expressed only cautious optimism about the current path, mentioning possible encouraging developments in production, while maintaining that the central bank has much more to accomplish.

"Not one of my FOMC colleagues is under any illusion," Warsh said. "We have begun a new chapter, and we understand that the five-plus years of inflation above target cannot be cured in nine weeks - or by a single month of modest price decreases."

This week's market action centered on the official inflation data and worries that holding rates steady might make price pressures worse. Treasury yields rose, most sharply at the long end of the curve.

Outlook

In a research note, Citigroup economist Andrew Hollenhorst wrote that trimmed-mean data "should also now fall closer to target-consistent rates."

"The fact that underlying inflation is still slowing toward target - as indicated by a broad set of indicators - is now even more relevant given Chair Warsh's suggestion that he would analyze inflationary pressure by looking across a broad range of metrics," Hollenhorst said.

"We expect markets to price-out rate hikes in coming months on inflation data, and price-in cuts if the unemployment rate rises as we project," he added.

The policy split and Warsh's pending review make the latest data especially important. With three Fed presidents pressing for tighter policy and Logan cautioning that the trimmed mean may be understating the true trend, investors are watching whether the cooling in these measures will persuade the Fed to hold the line on rates or eventually change course to cuts. A video segment on CNBC was titled "Fed likely to raise rates later this year, says Payne Capital's Courtney Garcia."

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