A year after U.S. inflation hit a 40-year high of 9.1%, it has fallen by about two-thirds. But bringing down annual consumer prices increases the rest of the way — to the more normal 2% level sought by federal policymakers — is expected to be a tougher slog.
Inflation cooled for a 12th straight month in June as more modest grocery price increases partly offset a rebound in gasoline costs and still hefty rent hikes. Core inflation, which the Fed watches more closely, eased more than expected.
Consumer prices overall increased 3% from a year earlier, down from 4% in May, according to the Labor Department’s consumer price index. That’s the smallest yearly increase since March 2021. On a monthly basis, prices rose 0.2% following a 0.1% increase in May.
How is inflation measured?
In the most basic sense, inflation is measured by comparing the current price of goods and services against their recent history.
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This is done by looking at a number of government-released data reports.
The CPI is the most prominent of these metrics. Released by the US Bureau of Labor Statistics, the Consumer Price Index measures the prices of goods in an urban market, which represents over 90% of the American public.
The CPI looks at a ‘fixed basket’ of some 80,000 goods and services to come up with these numbers. What gets put in that basket depends on the Consumer Expenditures Survey which polls Americans to determine which goods are important. The importance of those goods then determines their weight in the CPI– for example, the price of something like gasoline, which forms an integral part of many people’s cost of living, will contribute more than other items.
The CPI does not just have one version though. Another version – the Chained Consumer Price Index for All Urban Consumers is used to adjust tax brackets. The virtue of the Chained CPI is that it takes into account the substitution of similar items, which happens often when prices go up amid inflation. In doing this, it provides a more accurate look at consumer spending and doesn’t overstate inflation.
Inflation can also be measured through the price index for Personal Consumption Expenditures (PCE). This metric, released by the Bureau of Economic Analysis, takes a more holistic view. Rather than calculating the change in prices for goods paid solely out of pocket for consumers, the PCE takes into account all expenses, including health care coverage compensated by insurance.
The Fed considers the PCE the gold standard for evaluating inflation. The central bank has a 2% inflation target.
The final piece of the equation is ‘core inflation,’ which measures inflation but doesn’t count prices for food and energy which are more volatile.
How does raising rates fight inflation?
In order to control inflation, one of the Federal Reserve’s main tools is the federal funds rate, which is the rate banks charge each other for overnight loans. If that rate goes up, banks generally pass on their additional cost.
Even though the Fed does not directly control all interest rates in the country, when it raises the fed funds rate, other interest rates eventually follow, including those applied to adjustable-rate mortgages, credit cards, home equity lines of credit, and other loans.
Higher rates slow borrowing, cool off an overheated economy and ward off inflation spikes.
What is the difference between CPI and core CPI?
Core prices, which exclude volatile food and energy items and better reflect longer-term trends, have been tougher to subdue. They rose by a smaller-than-expected 0.2% after a three-month spurt of slightly stronger gains. That pushed down the annual increase from 5.3% to 4.8, the lowest since October 2021.
Broadly, the inflation picture has been mixed. Prices for used cars and other goods have been inching up more slowly or even falling as pandemic-related supply chain troubles have eased. But the cost of services such as haircuts and auto repairs have continued to advance crisply as wages have climbed amid COVID-induced labor shortages.
What’s the difference between CPI and PPI?
CPI measures inflation as experienced by consumers each day, while PPI, or producer price index, measures the average change over time in the selling prices received by domestic producers for their output. PPI, often referred to as wholesale price inflation, is measured at an earlier stage of the production and marketing cycle and tends to influence CPI, according to the Richmond Federal Reserve.
“Movements in the PPI have long been viewed as reflecting pricing changes early in the pipeline, and some analysts believe that such upstream pricing changes could be an early signal of future movements in downstream consumer prices,” Richmond Fed economists John O’Trakoun and David Ramachandran wrote last year.
June PPI is due at 8:30 A.M. Eastern Time on Thursday.
How much longer will the Fed raise rates?
Despite the significant easing of core inflation, most economists reckon it won’t be enough for the Federal Reserve, which watches that key price measure more closely. As a result, forecasters expect the Fed to raise interest rates again this month after pausing in June to assess the economic impact of its aggressive hiking campaign since early 2022. But the pullback in core price increases could prompt the Fed to hold rates steady the rest of the year.
What is the outlook for gasoline prices?
Gas prices rose 0.8% in June but are down 26.8% from a year earlier. Pump prices have been volatile but stayed relatively low amid lingering recession fears that have curtailed global oil demand and prices. Nationally, regular unleaded gasoline averaged $3.54 a gallon Tuesday, up from $3.59 a month ago but down from a peak of $5 in June 2022.
So why is CPI important?
The Federal Reserve makes interest rate decisions based on achieving its dual mandate of price stability and maximum employment. The Fed looks at CPI as one measure to gauge if prices are “stable” even though its stated inflation goal is PCE around 2%.
“CPI probably gets more press, in that it is used to adjust social security payments and is also the reference rate for some financial contracts,” the Cleveland Fed said.
The Fed’s next policy meeting ends on Wednesday, July 26. That afternoon, the Fed will announce its interest rate decision. Most economists expect the Fed to raise rates by a quarter point to bring its short-term benchmark fed funds rate up to a range of 5.25% to 5.5%.
Is CPI the only measure of inflation the Federal Reserve considers?
No. Actually, the Fed’s preferred inflation gauge is the Personal Consumption Expenditures price index (PCE) from the Bureau of Economic Analysis. PCE also is broken into headline and core but measures a different basket of goods and services and includes a wider group of people surveyed.
PCE measures price changes for all direct and indirect consumer consumption, not just literally what urban households are paying out of pocket like in CPI. For example, CPI would only capture what urban households pay out of pocket for medical expenses, but PCE includes costs covered by employer-provided insurance, Medicare, and Medicaid.
Also, PCE accounts for substitutions. “Thus, if the price of bread goes up, people buy less bread, and the PCE uses a new basket of goods that accounts for people buying less bread,” the Cleveland Fed said. “The CPI uses the same basket as before.”
CPI tends to run hotter than PCE.
What was PCE in May?
PCE prices rose 0.1% in May from April, compared with up 0.4% the previous month. Measured year over year, prices increased 3.8% in May, up from 4.3% in April. The year-over-year figure is down sharply from a 7% peak last June but far above the Fed’s 2% target.
Core PCE rose 0.3% in May from April and 4.6% from 12 months earlier. Year-over-year, the core PCE has changed little since it first touched 4.6% in December.
Stock futures: How are markets trading after the CPI report?
Futures tied to the broad stock market gauge, the S&P 500 index, rose 0.79% shortly after the inflation report landed. Futures connected to the blue-chip Dow were up 0.61% and the tech-laden Nasdaq-100 climbed 0.90%.
The 10-year Treasury yield fell to 3.92% as bond prices rose. Bond prices and yields move in opposite directions.
Fed rate hike: If inflation’s easing, why does the Fed keep raising rates?
The Fed may be afraid inflation isn’t cooling fast enough. The labor market is weakening, but not enough to lower CPI’s services rate and achieve the Fed’s 2% goal.
Last month, the economy added 209,000 jobs and the jobless rate fell to 3.6%. Average hourly earnings rose 12 cents to $33.58, nudging up the yearly increase to 4.4% from 4.3% and way above the 3.5% or lower that the Fed sees as aligning with its 2% inflation target.
It’s important for the Fed to lower inflation because as it has said, “higher prices for essential items, such as food, gasoline, and shelter, add to the burdens faced by many families, especially those struggling with lost jobs and incomes.”
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