Portfolio Strategy

March 25, 2022

The Big Idea

Getting to the core of inflation

Stephen Stanley | March 25, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The run-up in inflation in the spring of 2021 was mostly related to the reopening of the economy and reflected sharp advances in a handful of categories.  In contrast, the surge in inflation over the past six months has been entirely different, driven by a broad array of line items.  A close examination of the Dallas Fed’s trimmed-mean PCE inflation gauge illustrates the pervasiveness of inflation pressures. That gauge is likely shaping the Fed’s latest hawkish turn.

Dallas Fed trimmed-mean PCE measure

Economists came up with the notion of core inflation in the 1970s when food and energy prices skyrocketed.  The idea was to strip out the volatile categories to get at some more accurate sense of underlying inflation pressures.  However, it is arbitrary to work under the assumption that food and energy prices are always erratic and that everything else is always stable and an accurate indication of broader trends.

Economists at the Dallas Fed have since created a trimmed-mean PCE. Rather than assume food and energy prices are always the outliers, the trimmed-mean gauge lets the data decide.  Each month, 177 items are ranked from lowest to highest in terms of percent change. Then based on research to optimize the fit between the trimmed-mean gauge and the more familiar core PCE deflator, categories are cast aside until the cumulative weight in the index of the discarded items adds up to 24% on the lower end and 31% on the higher end. It is important to highlight that each category is weighted by its contribution to the overall PCE deflator so that it is not a certain number of line items excluded but a cumulative share of the overall index.

The remaining items, which make up roughly the middle 45% of the weight of the index, are used to calculate the trimmed-mean index for each given month.  The Dallas Fed reports the 1-month trimmed-mean inflation rate as an annualized figure and also calculates 6-month annualized and 12-month averages.

One-month percent change

The 1-month annualized percent change series for the Dallas Fed trimmed-mean PCE ran close to 2% before the pandemic, dipped for a brief time during the lockdowns, and then fluctuated around 2% into early 2021 (Exhibit 1).  There was not a single monthly reading above 3% until August 2021.  Recall that the core PCE deflator surged in the spring of last year, but it was driven by only a handful of categories linked to the economy’s reopening.  In fact, the core PCE increased at an annualized rate of more than 5% for four straight months beginning in March 2021, but the trimmed mean gauge barely budged.

Exhibit 1: Dallas Fed trimmed-mean PCE 1-month annualized percent change

Source: Dallas Fed.

In contrast, the rise in core inflation that began in late 2021 was much more broadly based.  The trimmed mean gauge on a 1-month basis jumped above 4% in September and surged to 6.7% in January, the highest reading since 1982.

One-month detail

The detailed breakdown for individual line items offers further insight into the breadth of inflation. Behind the Dallas Fed measure is a distribution of component price increases across a handful of buckets (Exhibit 2).  A year ago, more than half the weight of the index consisted of categories with 1-month annualized inflation rates of less than 2% while about 30% of the cumulative weight of the index was posting annualized inflation rates over 5%.  However, by January 2022, the latest available reading, just over 20% of the index came in at 2% or lower, while nearly 70% of the line items were running above 5%, including almost 40% above 10% and 14% over 20%.

Exhibit 2

Source: Dallas Fed.

Trouble for the Fed

It is easy to understand how Fed officials were willing to write off the jump in inflation in the spring of 2021 as transitory since it was being driven by just a few categories.  However, the recent surge in prices looks very different, sparking the abrupt turnaround, albeit belatedly, in the Fed’s monetary policy stance.  The breadth of price increases points to economy-wide drivers of the acceleration in inflation, including steep wage hikes caused by an overheated labor market and an imbalance between supply and demand across major swaths of the economy.

The January headline and core PCE deflators in January were not meaningfully higher than the monthly readings in late 2021, but the trimmed-mean PCE gauge for the month spiked by almost 2 percentage points on an annualized basis.  While the general public and even most market participants are largely unaware of the Dallas Fed data, Fed officials have for years followed them closely and were undoubtedly alarmed by what they saw for January.  The widening breadth of inflation in January may help to explain the abrupt conversion of Fed officials from doves to hawks over the past few months and is likely to influence FOMC behavior for the foreseeable future.

Stephen Stanley
1 (203) 428-2556
sstanley@apsec.com

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