The Big Idea
Redefining inflation lower
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The core PCE deflator has surged this year, leading to alarm within the FOMC and among economists and financial market participants. There is hope in some circles that inflation will come down on its own as tariff-related passthrough dissipates and perhaps if energy prices eventually recede. The US Bureau of Economic Analysis is doing its part, implementing three changes in methodology that should lower inflation at the margin. But it’s unlikely to be enough to ease policymakers’ concerns about inflation.
Methodological changes
Once a year, the BEA revises the GDP accounts, incorporating new data and making any necessary methodological refinements. This year’s annual revisions will come at the end of September.
It has caught the attention of many observers that the BEA has announced changes in the way that it will calculate prices for three categories of the PCE deflator: portfolio management fees, computer software, and legal services. These represent three areas where there have been well-known flaws in the price calculations, so the changes, which some have cynically suggested are being adopted to engineer inflation lower, strike me as a reasonable attempt to address longstanding problems in the PCE deflator.
Portfolio Management. I have long pointed to the spurious methodology that the BEA has used to calculate prices for portfolio management. Many investment managers get paid by a combination of a fixed charge on assets and a percentage of investment returns. What this means is that investors pay more to their investment managers when the markets rise, and vice versa. By using the PPI for portfolio management and investment advice services, the BEA has been conflating market moves with prices, as the PCE deflator gauge for this line item has long been tightly correlated with the direction of the stock market.
The BEA’s new methodology does not strike me as perfect, but it should be an improvement. The BEA is going to use employment count in the industry as a proxy for real output. So, the deflator will simply be a residual that is spit out by taking the ratio of the nominal spending figure to the employment-based “real” number. For what it’s worth, this new methodology is likely to make it much more difficult for economists to project the line item, especially early on.
Economists predict that this change could lower the overall PCE deflator by one to two tenths of a percentage point.
Computer Software. Currently, as is the case for the majority of categories in the PCE deflator, the PCE deflator for computer software simply uses the corresponding CPI line item (with a different weight). Unfortunately, the CPI for computer software and accessories has been polluted by the fervor of the AI buildout. Certain items that are more hardware than software, like flash drives, that have seen steep price hikes are included in the CPI gauge. As a result, the CPI component at the current juncture does not offer a clean view of the prices that consumers face for software. This is not a major problem for the CPI, because the weight of the line item is infinitesimally small, 0.03% of the overall CPI. In contrast, the weight for the PCE deflator is 1.1%. As a result, the 14.5% year-over-year jump in computer software contributed 16 bp to the 4.1% 12-month advance in the PCE deflator.
To address this issue, the BEA will use a composite index that will be derived from the CPI component, the PPI for game software publishing, the PPI for hosting server pages, and the PPI for other IT infrastructure provisioning services.
The consensus is that the new composite index may bring down the overall PCE deflator inflation measure by around a tenth of a percentage point.
Legal Services. The legal services line item of the PCE deflator is another one that is a simple passthrough of the corresponding CPI category but with a different weight. The problem is that the Bureau of Labor Statistics has developed problems with the CPI gauge for legal services. The BLS has stopped publishing the legal services results because they do not meet the BLS publication quality guidelines. The numbers have recently recorded implausibly large swings that are not consistent, according to the BEA, with other source data.
Incidentally, the fact that the BLS has ceased publishing the legal services figures has meant that forecasting that component in the PCE deflator had become nothing more than a guess. As with computer software, the weight for this category is much larger in the PCE deflator (0.8%) than for the CPI (0.3%). As it happens, the BEA has simply penciled in a zero for the category in six of the past eight months, but the January jump of 1.8% added about 1.5 bp to the monthly advance in the core PCE deflator.
The BEA going forward will use a composite price index that uses detailed PPIs for selected legal services consumed by households instead of the unreliable CPI line item.
This change is widely expected to raise the PCE deflator, providing a partial offset to the other two alterations. The net impact of the three changes is expected to lower the year-over-year advance in the PCE deflator by one to two tenths of a percentage point.
Policy implications
In a different context, these changes could have been a big deal. Consider if the core PCE deflator was running at 2.4% on a year-over-year basis, and the BEA were to revise that figure to 2.2%. That would be a meaningful difference. Or think about the implications for the Fed if the core PCE deflator was revised from 1.8% to 1.6%.
However, the year-over-year readings through May were 4.1% for the headline PCE deflator and 3.4% for the core gauge. Trimming a tenth or two off of those numbers still does not get inflation anywhere near the Fed’s 2% target. A number of economists and financial market participants have argued that the methodological revisions will be enough to convince the FOMC to hold off on rate hikes this year. I disagree. In my view, a downward adjustment of a tenth or two of a percentage point would not be enough to assuage the concerns of policymakers regarding inflation.
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