MONEY The Economy

Inflation Is Above the Fed’s 2% Target. So Why Aren’t Rates Going Higher?

While the consumer price index has drifted above 2% for the first time since October 2012, Fed officials prefer a different measure of inflation.

For several years now, the Federal Reserve has publicly set a target for where it wants inflation to be, and that goal is 2%.

In fact, as MONEY’s Pat Regnier points out, one of the reasons the Fed gives for keeping short-term interest rates so low is that the economy has been running below capacity — and a tell-tale sign of that is a lack of inflation, which tends to rise as the economy heats up.

Well, on Tuesday morning, the Labor Department released new figures that show that over the past 12 months, the consumer price index — perhaps the most widely cited measure of inflation — rose 2.1%. As recently as March, CPI was growing at an annualized pace of just 1.5%, well below the Fed’s target. So when Fed officials meet today and tomorrow to discuss what to do about interest rates — as well as its stimulative bond buying program — they’ll be forced to raise rates, right?

Actually, no.

Why? For starters, while CPI is the most widely cited gauge of prices, there are actually several ways to measure inflation, and Fed officials are on record stating that they look at a variety of measures.

For instance, while the Labor Department’s May CPI report shows that overall inflation rose 2.1%, that same report showed that so-called core CPI — which strips out volatile energy and food costs — is rising at just under 2%:

US Consumer Price Index Chart

US Consumer Price Index data by YCharts

Now, you may argue that food and energy costs are essential to understanding inflation because they take such a big bite out of household expenses. Still, as this explainer that the Federal Reserve Bank of San Francisco put out a while back discusses, food and energy costs are substantially more volatile than other consumer prices, often spiking one month and sinking the next based not on long-term economic trends, but rather on short-term drivers in specific commodity markets. And commodity prices in general are influenced by goings on in the global economy, not just the U.S.

As a result, the Fed prefers to look at core prices.

Fed officials also prefer an altogether different government measure of inflation, known as the core personal consumption expenditure deflator, or PCE deflator.

There are many technical differences between the PCE deflator (which is put out by the Bureau of Economic Analysis) and CPI (which is put out by the Department of Labor). But in general the PCE deflator measures a much broader group of goods and services. Plus it measures trends found among a broader cross-section of Americans. For instance, the experiences of rural households is included in the PCE deflator, but not in CPI.

Here’s what former Fed chairman Ben Bernanke noted about the PCE deflator back when he was just a Fed governor:

Relative to the more familiar consumer price index (CPI), the PCE deflator (1) has broader coverage, (2) is believed to be based on more accurate expenditure weights, (3) is constructed in a manner that reduces so-called substitution bias, (4) is measured more consistently over time, and (5) arguably does a better job measuring medical inflation. The core PCE deflator excludes volatile components, notably the prices of food and energy. Core inflation measures in general are probably better indicators of the underlying rate of inflation, with which central banks are typically most concerned.

And the most recent PCE deflator readings show that inflation is running at a much tamer 1.4%:

US PCE Quarterly Inflation Rate Chart

US PCE Quarterly Inflation Rate data by YCharts

So if you’re waiting for Fed chair Janet Yellen to hike rates this year, don’t hold your breath.

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