Note to Fed Watchers: It Doesn’t Target the ‘Preferred’ Gauge

Disclosure: What follows is a rant on a subject most never notice. One that grows more irritating (to me) with almost each and every passing Fed meeting. “Preferred” and “target” aren’t synonyms.

Perhaps that is obvious. It should be. Yet it seems many Fed watchers presume the central bank “targets” 2% y/y inflation as measured by its supposedly “preferred” core personal consumption expenditures (PCE) price index, which excludes food and fuel. But it doesn’t. It targets the headline PCE, including those categories. Investors—and frankly, the Fed watchers who question policymakers—would do well to understand this distinction. All too often, it seems they don’t.

Pundits have long presumed core PCE to be the Fed’s “preferred” inflation gauge. So when the Fed started targeting inflation last decade, many conflated their perception of “preferred” with the Fed’s target. So much so, actually, that pundits and reporters commonly say the Fed targets core PCE. Reporters in July stated that, “The Fed uses the core PCE index as the benchmark for its 2% inflation target.”^[i] Papers from select economic think tanks arguing the 2% target is too low base their discussions and visuals on core prices.^[ii] Entire columns in venerable financial publications hinge on core PCE as the measure for whether the Fed is nearing its target. These aren’t isolated examples—scores of pundits write op-eds galore on the same presumption.

Look, I have no idea what the Fed or various officials actually prefer. Maybe some do prefer core PCE. Perhaps others prefer that Thanksgiving Dinner index the American Farm Bureau publishes annually in November. Maybe some of them really like a weird price index no one in the public has ever seen. But whatever they prefer, it is plain to see what the Fed targets, and it isn’t core PCE.

When the Fed formally established its 2% y/y inflation target in 2012, it said, “The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.”^[iii] (Boldface mine.) That is headline, not core.

Sound vague or squishy? Consider: Two weeks after establishing that formal target, St. Louis Fed President and FOMC member James Bullard gave a speech and stated, “In a targeting context, inflation means headline inflation. It does not make sense to ignore some inconveniently volatile prices, like those for gas or food, when discussing the inflation rate actually faced by U.S. households.”^[iv]

The Cleveland Fed’s Q&A page on inflation states, “The Federal Reserve sees a rate of inflation of 2 percent per year—as measured by a particular price index, called the price index for personal consumption expenditures—as the right amount of inflation.” The San Francisco and New York branches echo this. And, in case you wondered whether they changed the target after first establishing it 11-plus years ago, Bullard wrote a paper prior to leaving the Fed this year that included the following footnote: “The FOMC’s 2% target is based on the headline personal consumption expenditures (PCE) price index.”^[v]

This isn’t one of those cases where fedspeak—notoriously impenetrable language designed to give policymakers wiggle room—applies. It is clear. But at the Q&A following last week’s decision to keep rates on hold, a reporter asked Fed Chair Jerome Powell whether oil prices’ uptick would enter into Fed decision making going forward. Here is his response:

After an interjected follow-up question, Powell continued:

These statements are fair and fine at face value, but they make sense only if you presume the Fed targets core prices. There was no follow-up on this. No one pressed Powell on why the Fed would target a headline rate but claim it must look past oil’s volatile wiggles. This is a logical disconnect we would all do well to hear Powell spin his way out of.^[vii] Alas, we don’t seem likely to get that. The conflation of “preferred” and “target” is too global.

We have long argued Fed words—and deeds—matter a whole lot less than many think and that their actions aren’t forecastable. That stands now. But many pundits and Fed watchers still try. With that in mind, doesn’t it seem ironic so many fail to account for which gauge underpins the policy instrument central to the current inflation and policy debate? At its peak last year, the divide between headline and core PCE was two full percentage points.^[viii] In light of a Fed that wrongly thinks it can fine-tune inflation down to a fraction of a percentage point, this seems like a substantial omission Fed watchers may want to rectify.