Geetanjali Pande

James B. Bullard

English

Research Papers in Economics

April 2007 NationalEconomicTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
T
he Federal Open Market Committee (FOMC) has
responsibility for the long-run inflation rate for
the U.S. economy and therefore needs a reliable
indicator of trend movements of inflation. Currently, the
Committee focuses on the personal consumption expendi-
tures (PCE) inflation rate—in particular, on the core rate.
The core rate excludes food and energy, two components
that, since 2000, together account for approximately 18
percent of the index, about 13 percent food and 5 percent
energy. Policymakers generally consider the energy com-
ponent, in particular, to be too volatile to inform their
month-to-month deliberations. But is it a good idea to
exclude prices that are, after all, faced by consumers,
when trying to read movements in trend inflation?
A trend inflation indicator that is often used is PCE
inflation measured from one year earlier. The chart shows
inflation rate data since 2000. Pictured are the inflation
rates for the PCE, the core PCE, and the energy compo-
nent of the PCE. The chart indicates that the energy com-
ponent is quite volatile, as expected. If the core PCE
concept is valid, the energy component
should be sometimes above and some-
times below the PCE inflation rate, as it
was in 2001 and 2002. In this situation,
the core concept removes a volatile com-
ponent and gives the Committee a better
indicator of trend inflation movements.
However, the data since 2003 show a
persistent divergence in the overall and
core PCE inflation rates, as the inflation
in the energy component has remained
high. For this time period, excluding
energy prices simply amounts to putting
zero weight on the prices that are increas-
ing at the most rapid rate. Accordingly,
the chart indicates that the core PCE
inflation rate has averaged about 1.94
percent per year, while the PCE has aver-
aged 2.56 percent during this period. One
could interpret this as a sustained under-
statement of the true trend inflation rate,
rendering the core measure a misleading trend inflation
indicator for policymakers.
The problem is this: Instead of simply being volatile,
energy prices moved to a higher level and have remained
at the higher level. That means that the relative price of
energy has increased more or less continuously for the
past several years. Given our relatively inelastic demand
for energy, at least in the short run, all of us consumers
were forced to spend more on energy and less on all other
goods. From this source we expect downward pressure
on the prices of all non-energy goods and services. Once
the relative price change is complete, we would expect
energy prices to be volatile around their new, higher level,
but again grow at the same rate on average as the prices
of all other goods. As the chart indicates, during the tran-
sition toward a higher relative price of energy there was a
sustained gap between the overall and core PCE inflation
rates. We conclude that excluding energy prices may not
be a good idea during a period of relative price change.
—James B. Bullard and Geetanjali Pande
research.stlouisfed.org
Energy Prices: In the Mix or Swept Under the Rug?
Personal Consumption Expenditures
–2
–1
0
1
2
3
4
5
6
7
8
 2000:Q1 
 2000:Q3
 2001:Q1 
 2001:Q3
 2002:Q1 
 2002:Q3
 2003:Q1 
 2003:Q3
 2004:Q1 
 2004:Q3
 2005:Q1 
 2005:Q3
 2006:Q1 
 2006:Q3
Percent Change from One Year Earlier
–16
–12
–8
–4
0
4
8
12
16
20
24
Energy Component of 
PCE Inflation Rate
PCE 
Inflation Rate
Core PCE 
Inflation Rate
Percent Change from One Year Earlier
(Energy Component)

Energy prices: In the mix or swept under the rug?

http://research.stlouisfed.org/publications/net/20070401/cover.pdf

Energy prices: In the mix or swept under the rug?

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