Inflation has remained below the FOMC’s long-run target of 2% for more than three years. But this sustained undershooting does not yet signal a statistically significant departure from the target once the volatility of monthly inflation rates is taken into account. Furthermore, the empirical Phillips curve relationship that links inflation to the size of production or employment gaps has been roughly stable since the early 1990s. Hence, continued improvements in production and employment relative to their long-run trends would be expected to put upward pressure on inflation.
The Federal Open Market Committee’s statement of longer-run goals indicates that a 2% inflation rate, as measured by the 12-month change in the price index for personal consumption expenditures (PCE), is consistent with the Committee’s statutory mandate for ensuring stable prices (Board of Governors 2015b). The FOMC’s preferred measure of inflation has remained below 2% for more than three years, even though both production and employment have improved substantially over the same period. In its statement following the June 17 meeting, the FOMC said it “expects inflation to rise gradually toward 2% over the medium term as the labor market improves further and the transitory effects of earlier declines in energy prices and import prices dissipate” (Board of Governors 2015a).
This Economic Letter compares the recent behavior of PCE inflation with earlier periods going back to the early 1990s. It turns out that recent inflation behavior departs only mildly from earlier patterns. Taking into account the volatility of monthly inflation rates, the recent departure of 12-month inflation from the 2% target rate does not appear particularly significant or permanent in comparison with earlier episodes. Moreover, since the early 1990s, the empirical Phillips curve relationship that links inflation to the deviations of production or employment from their longer-term trends appears roughly stable. Hence, continued improvements in production and employment relative to their long-run trends would be expected to put upward pressure on inflation.
To illustrate inflation’s recent behavior, Figure 1 shows monthly inflation rates as measured by the one-month percent change in the PCE price index from January 1992 to May 2015. The horizontal dashed line at 0.165% is equivalent to a 12-month compound inflation rate of 2%, which corresponds to the FOMC’s long-run inflation target. In other words, if monthly inflation were 0.165% for 12 consecutive months, the resulting 12-month change in the PCE price index would exactly equal 2%.
The gray bars show that monthly inflation rates are highly volatile, fluctuating above or below the target-equivalent rate of 0.165%. The red line shows the trailing 12-month geometric mean of the monthly rates. This statistic measures the average compound monthly inflation rate over the past year—corresponding to the FOMC’s preferred measure of inflation. The 12-month mean also spends considerable time above or below the target. From May 2012 until the end of the data sample in May 2015, the 12-month mean has remained below target for 37 consecutive months. While this is a long spell, it is not entirely out of line with previous episodes shown in Figure 1. For example, from April 1997 to December 1999, the 12-month mean remained below target for 32 consecutive months. And from April 2004 to August 2006, the 12-month mean remained above target for 29 consecutive months.
One way to gauge whether a departure of inflation from target is statistically significant is to show how much uncertainty surrounds recent inflation readings. While the 12-month mean measures the recent level of inflation, the trailing 12-month standard deviation measures the recent volatility of inflation. Adding and subtracting the 12-month standard deviation from the 12-month mean defines a range of inflation rates—known as an uncertainty band—that takes into account the fact that monthly inflation, like any economic statistic, is subject to temporary random shocks and measurement error.
Going back to the early 1990s, the uncertainty band surrounding the 12-month mean (defined by the area between the yellow lines in Figure 1) has almost always included the target rate of 0.165%. Small and brief exceptions occurred in early 1998 and late 2007. An interesting feature is that the uncertainty band has become noticeably wider since 2000, mainly due to the higher volatility of energy prices, which are included in the PCE price index. The uncertainty band continues to include the target rate toward the end of the data sample, meaning that the recent sustained departure of the 12-month mean from the target does not yet signal a permanent downward shift in the level of inflation. Rather, the departure remains within the range of typical fluctuations in monthly inflation that arise from temporary factors.