Underlying Inflation Falls to Lowest Level in Five Years

The Bureau of Economic Analysis released a report on Wednesday indicating that the personal consumption expenditure price index increased by 0.4% in February, a slight rise from 0.3% in January. Notably, commodity prices rose by 0.7%, largely led by a 1.1% increase in durable goods. Items like recreational equipment and automobiles saw a significant rise of 2.2%. At first glance, this might seem like a concerning inflation report that could make the Fed cautious.

However, digging a little deeper reveals a different story. When measuring basic trends in inflation—effectively filtering out some misleading categories—the situation improved in February.

A key indicator of underlying inflation is the trimmed mean calculated by the Dallas Fed, which stands at 16%. This method eliminates the most volatile price changes from the monthly data, allowing for a clearer view of what’s happening in the middle. As such, the monthly annualized trimmed average for February dropped to 1.82%, down from 2.71% in January, reflecting a significant slowdown. Furthermore, the six-month annualized rate decreased below 2%, settling at 1.99%, marking the lowest point since March 2021. The 12-month rate followed suit, declining to 2.33%, another low since 2021.

Additionally, the Cleveland Fed’s median PCE, which focuses on price changes at the distribution’s midpoint, decreased from 2.89% in January to 2.79% in February. This drop extends the decline from over 3.4% noted last summer. The six-month annualized median PCE inflation rate also fell, landing at 2.25%, the most moderate since April 2021.

These metrics provide a clear message. The February acceleration in headline and core PCE appears to be driven by outliers, rather than broad pricing pressures. Several categories showed notable increases, such as recreational goods and clothing, yet overall price fluctuations across the economy seem to be diminishing.

Underlying Inflation Declines Despite Strong Spending

This current situation contrasts sharply with what would typically indicate a real resurgence of inflation. If overall inflation were rising, we’d expect to see the trimmed mean and median increase alongside the headline figures. Yet, with certain volatile categories pushing headlines up, other prices remain stable—this divergence occurred in February.

When examining the service sector, we see a similar trend, with service prices climbing just 0.2% in February, down from 0.4% in January. This aligns with the weaker monthly data observed on multiple occasions over the past year. Housing and utility costs kept rising, but by a mere 0.2%, indicating a gradual moderation.

It’s worth reflecting on where these trend indicators stand in relation to the Fed’s 2% target. The adjusted six-month average annual rate was at 1.99%, which aligns closely with that target, while the 12-month rate dropped to 2.33%. The direction appears consistently clear over recent months.

This doesn’t imply that inflation has been completely tamed. With the median PCE at 2.79% compared to last year, there’s still work to be done. Yet, the direction of progress is unmistakable, and the rate of decline is notable. Just a year ago, discussions revolved around whether inflation was stuck above 3%. That debate seems to be settled now.

It’s also important to note that these measurements included the impacts of recently lifted tariffs. Thus, the subdued trend in inflation doesn’t stem from tariff reductions.

Moreover, it’s crucial to consider that the changes in underlying inflation aren’t due to a slump in personal consumption. In February, personal consumption spending rose by 0.5%, with notable increases across various sectors like vehicles, healthcare, clothing, transportation services, and recreational goods.

The risk for the Fed lies in focusing too heavily on the headline numbers while overlooking what underlying trend indicators reveal. Headline PCE figures driven by a few volatile categories differ significantly from those influenced by widespread price pressures. The trimmed mean and median are designed to highlight this distinction, and currently, they suggest a picture of an economy where the inflation problem is nearing resolution.