| Keep an eye on the “wedge.” No, not the women’s shoe style nor the iceberg lettuce salad. The wedge to watch is the widening gap between two measures of core inflation that can have an impact on monetary policy or on the prices of inflation-protected securities, or TIPS. One measure, the Consumer Price Index (CPI), often gets media attention and matters a good deal in the TIPS market. The other, the Personal Consumption Expenditures Price Index (PCE), is what Federal Reserve policymakers are watching when they’re talking about a 2.0% inflation target. Over time, the two data series trend together, but measurement differences have resulted in a persistent spread, or wedge, between the year-over-year pace of growth in core CPI and core PCE.
MEASUREMENT DIFFERENCES.
Historically, the wedge has typically run around 0.25 percentage points, with the CPI outpacing the PCE, largely due to technical and compositional differences. The PCE is a chain-weighted measure, whereas the CPI is fixed-weighted. This means that changes in consumption will impact the weights of goods and services in the PCE, so this will affect PCE reporting as consumers shift spending between higher- or lower-priced goods. In contrast, the CPI is based on a fixed basket of goods and services. This difference has been the primary driver of the trend average gap between the two indexes.
More recently, critical CPI and PCE components are moving apart. The relative weights for the key categories of housing and medical services and a different conceptual basis for medical-services prices have helped to drive the wedge higher to about 0.5 percentage points. In the CPI, housing has been trending up for five years while the rate of gain in the PCE’s medical-services measurements has been in decline, largely due to reimbursement rates paid to doctors and hospitals by federal and state governments and private insurers. Moreover, we estimate that, given our TIPS strategists' bullish case for owners' equivalent rent and rental prices in the CPI, the wedge could grow to an astounding 0.8 percentage points (see chart). Housing comprises 42.1% of the CPI but only 17.7% of the PCE.
POLICY IMPLICATIONS.
Since the hyperinflation of the 1970s the Fed has fought hard to establish its inflationfighting credibility and has largely gained the market’s confidence. In the short run, the Fed allows for some fluctuation around its goal. To be fair, over the forecast horizon some policymakers have stressed there is a reasonable band around its 2.0% PCE goal of plus or minus one percentage point. The latest central tendency forecast suggests it will hit the target in 2017.
The wide and growing wedge has important implications for the TIPS market, as it trades around the CPI data. A wedge of 0.8 percentage points implies that CPI inflation would have to reach 2.5% or greater to achieve a 2.0% PCE inflation target. In the market for TIPS, based on the current CPI-PCE wedge of 0.5 percentage points, 30-year breakevens at 2.0% imply a very low likelihood of the Fed meeting its inflation mandate—an unreasonable expectation, in our view. We believe the current negative inflation risk premium priced into breakeven rates is likely to correct. If the Fed meets its 2.0% PCE inflation goal in the medium term, then 30-year breakevens at 2.0%, implying 1.5% PCE inflation based on the current wedge, would likely prove to be a bargain, according to our TIPS strategists. |
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