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Inflation across the country has been slowing, which is good news for consumers. However, a new University of Hawaiʻi Economic Research Organization (UHERO) blog shows why we need to approach the second half of 2023 with cautious optimism.

The Fed’s war on inflation has been underway for more than a year. Interest rates have been driven up sharply, with consequences for the macroeconomic outlook—will the economy just slow or drop into a steep recession—but also for households and businesses, wrote Byron Gangnes, UHERO senior research fellow and professor emeritus of economics. Many families have been priced out of the housing market or had to postpone buying a needed car. Small businesses are having a much harder time accessing credit even at relatively high interest rates.

The prospects for inflation will influence whether the Fed is done raising rates or even begin to cut them. The good news is that inflation has been slowing. But how fast it will continue to fall is less clear and the prospects depend a lot on where you look.

Consumer price inflation

There are two main measures of consumer price inflation. The consumer price index (CPI) measures prices of goods and services purchased directly by the typical urban household. The personal consumption expenditure (PCE) deflator, collected from business data, measures a broader set of consumer purchases, whether made by a household directly or on their behalf by businesses, government and nonprofits. Both measures show a downward trend in inflation, and show inflation falling by roughly half from the peak in the middle of last year.

According to Gangnes, there are several things to note:

  • Overall inflation is different according to the CPI and PCE measures, with PCE typically running lower than CPI. CPI inflation over the 12 months ending in April was 5%; according to the PCE, inflation was running 4.4% in April.
  • Goods price inflation has receded significantly by both measures, and energy price inflation has turned slightly negative.
  • The contribution of housing and utilities has been much larger by the CPI measure than by the PCE.
  • And the contribution of the “other services” category (everything except housing and utilities) has been much larger for the PCE measure than it has for the CPI.

Path going forward

The differences in the elements contributing the most to inflation are potentially very important for what they tell us about the likely path of inflation going forward, according to Gangnes. Because rents are falling, we expect housing inflation to come down significantly in coming months. But there is much less reason to expect a sharp drop in inflation of other service prices. The latter are labor-intensive activities where substantial labor market weakening may be needed before price increases begin to ease.

Gangnes points out that CPI and PCE have significant differences in the way certain categories are weighted, in particular, the estimate of shelter costs and health care.

So why should we care about the different messages coming from CPI and PCE inflation?

“Because the Federal Reserve sees the latter as a better measure of inflation and relies on it when setting interest rate policy,” according to Gangnes’ blog. “A key concern of the Fed has been the behavior of the ‘other services’ category (including transportation and medical services), which by the PCE measure continues to be the biggest driver of ongoing inflation, with little evidence of slowing. If this continues to be the case, the Fed is more likely to keep interest rates higher for longer, or even make additional interest rate hikes in coming months. That would be painful news for all of us.”

See UHERO’s website for the entire blog.

UHERO is housed in UH Mānoa’s College of Social Sciences.

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