Pricing data released in June suggests that, with the exception of a select group of goods still experiencing price increases, inflation is moving closer to the Federal Reserve’s long-standing target. This shift in inflationary trends, particularly as reflected in measures that exclude volatile price swings, is drawing attention from policymakers and market participants alike, especially in the context of Federal Reserve Chairman Kevin Warsh’s stated intention to reassess the central bank’s approach to inflation monitoring.
The Dallas Federal Reserve’s trimmed mean inflation measure, which systematically removes the highest and lowest price change outliers, indicated a one-month annualized rate of just 1.4% for June. This represents a significant decrease of 1.3 percentage points from May and marks the lowest level observed since November 2020. Furthermore, the 12-month rate, a metric closely watched by Federal Reserve policymakers for its broader perspective on inflation, declined to 2.2%. This figure is down by 0.2 percentage points from the previous month and represents a low point not seen since July 2021.
While Federal Reserve officials typically emphasize that they do not base policy decisions on any single month’s data, the sustained downward trend in the trimmed mean measure is likely to be a significant point of discussion. This is particularly true given Chairman Warsh’s public commitment to re-evaluate how the Federal Reserve perceives and measures inflation, signaling a potential shift in the data points considered most influential.
Andrew Hollenhorst, an economist at Citigroup, noted in a recent client note that these trimmed mean measures "should also now fall closer to target-consistent rates." He elaborated, stating, "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. 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."
Understanding Trimmed Mean Inflation Measures
The concept behind trimmed mean inflation measures is akin to a teacher grading on a curve, aiming to identify the central tendency of price changes by excluding extreme observations. The Dallas Fed’s methodology, for instance, discards the lowest 24% of price readings and the highest 31% of price increases. This process is applied to the Personal Consumption Expenditures (PCE) price index, which serves as the Federal Reserve’s primary inflation forecasting tool. The PCE data for June, released by the Commerce Department, revealed a monthly decline of 0.1% in the all-items index, largely attributed to a sharp drop in fuel costs. The core PCE index, which excludes the volatile food and energy components, saw a more modest increase of 0.1% for the month. On an annual basis, the all-items PCE index rose by 3.7%, while the core PCE index increased by 3.3%.
A similar approach is employed by the Cleveland Federal Reserve, which calculates a "16% trimmed mean" inflation rate. This measure includes price changes within the 8th and 92nd percentiles, excluding the top and bottom 8% of price movements. However, the Cleveland Fed’s trimmed mean utilizes the Consumer Price Index (CPI) as its benchmark. For June, the trimmed CPI registered at 2.63%, which, when unrounded, represents the lowest figure since May 2021.
The potential for these trimmed mean measures to gain greater prominence in the Federal Reserve’s analytical framework under Chairman Warsh is significant. However, there are important caveats to consider when interpreting these figures.
Skepticism and Nuance in Inflation Data
Lorie Logan, President of the Dallas Federal Reserve and overseer of its trimmed mean measure, has previously cautioned against placing excessive reliance on these figures due to what she describes as "compositional factors." Specifically, she has indicated that her research team has observed 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."
This concern was a contributing factor to Logan’s dissent at the most recent Federal Open Market Committee (FOMC) meeting, where she advocated for a quarter-percentage-point interest rate hike. She argued that even after accounting for productivity gains and temporary supply shocks, inflation appears to be trending toward the mid-2% range rather than fully reaching the Fed’s 2% target, with risks leaning towards the upside. Logan was joined in her dissent by Minneapolis Fed President Neel Kashkari and Cleveland Fed President Beth Hammack, both of whom expressed apprehension about persistently high inflation and advocated for more immediate action.
The market’s reaction to the Fed’s decision to hold rates steady also highlighted ongoing inflation concerns. Bond yields, particularly at the longer end of the maturity spectrum where investors price in future economic growth and inflation expectations, surged following the announcement. This indicates a market sentiment that the Fed’s current stance might not be sufficiently aggressive in combating inflation.
Chairman Warsh himself has expressed a degree of tempered optimism regarding the current inflation trajectory. While acknowledging some positive signals from production data, he has stressed that the Federal Reserve has "a lot of work to do." He further stated, "Not one of my FOMC colleagues is under any illusion. 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 statement underscores a recognition that sustained inflation requires a long-term and comprehensive strategy, rather than being swayed by short-term fluctuations.
Historical Context of Inflation and Fed Policy
The Federal Reserve has been engaged in a prolonged battle against inflation that has persisted above its 2% target for over five years. This extended period of elevated price pressures has been attributed to a confluence of factors, including robust consumer demand fueled by fiscal stimulus measures, lingering supply chain disruptions from the global pandemic, and geopolitical events impacting energy and commodity prices.
The central bank’s policy response has involved a series of interest rate hikes, beginning in early 2022, aimed at cooling demand and bringing inflation back under control. The aggressive pace of these rate increases, however, has raised concerns about the potential for an economic slowdown or even recession. The recent pause in rate hikes, therefore, represents a delicate balancing act, seeking to gauge the impact of past tightening while remaining vigilant against resurgent inflation.
Broader Economic Implications and Future Outlook
The debate surrounding inflation measurement and policy response has significant implications for the broader economy. If inflation proves more persistent than current trimmed mean measures suggest, the Federal Reserve may be forced to resume interest rate hikes, potentially increasing the risk of a recession. Conversely, if inflation continues to trend downwards, as indicated by these measures, the Fed could have room to consider interest rate cuts, which could stimulate economic growth but also risk reigniting inflationary pressures.
The emphasis on a "broad range of metrics" by Chairman Warsh suggests a potential evolution in the Fed’s analytical toolkit. This could lead to a more nuanced understanding of inflationary dynamics, taking into account factors beyond headline price changes. The inclusion of measures like the trimmed mean, which attempt to filter out noise from volatile price components, could provide a more stable and reliable signal of underlying inflationary trends.
Economists are closely monitoring several key indicators to assess the future path of inflation and monetary policy. These include the unemployment rate, wage growth, consumer spending patterns, and global commodity prices. The interplay of these factors will ultimately shape the Federal Reserve’s decisions and their impact on businesses and households. The current environment underscores the complexity of navigating modern economic challenges, where data interpretation and forward-looking policy are paramount. The coming months will be critical in determining whether the current signs of cooling inflation are a durable trend or a temporary respite in the ongoing battle against rising prices.
