PCE Index Deeply Flawed

Not only is the Fed’s inflation of 2% both too low and too precise, it is also based on a deeply flawed PCE index.  Specifically, the PCE index uses the shelter component  from CPI that is delayed by two years relative to market rents, but also uses imputed prices that are completely disconnected from market inflation.  The imputed estimate of financial services is the most distorted with increases in stock prices resulting in imputed inflation as investors pay higher management fees even though management fees remain unchanged.  In addition, the BEA performs other arcane and likely unreliable estimates of increases in the prices of deposit accounts based on changes in interest rates and insurance inflation based on loss rates vs. actual insurance rates. The imputed financial services component of PCE raised Y/Y inflation by .5% relative to a market-based estimate, which caused Y/Y PCE core to be 3.1% vs. a market rate of 2.5%.

We publish a Realflation measure of PCE core that uses market rents and market financial services inflation to measure the real market inflation rate.  PCE-R for the last twelve months was 1.9%, which indicates the Fed should cut the Fed Funds rate to the neutral rate of 2.75% as soon as we get clarity on oil prices post resolution of the Iran war.