Inflation hawks have ratcheted up inflation expectations with limited results. They are like the guy whose ship came in while he was at the airport. They base inflation expectations on CPI when the Fed measures PCE. Dr Stephen Williamson destroyed the inflation hawks back in April of 2017, but most of the pundits were not paying attention.
The Consumer Price Index (CPI), measures the cost of living by measuring a pre-chosen basket of goods. The CPI includes everything, including food and energy. The Personal Consumption Expenditures (PCE) index does not include the cost of food and energy because they are volatile and change often. The Fed seeks to measure underlying inflation.
The Fed looks, as Dr Williamson has said, at PCE, not at CPI. And since the Fed looks at PCE, the St Louis Fed Vice President says inflation expectations based on CPI are not valid. By the time that the CPI reveals a bias against inflation, the watchers of PCE can say they already knew that was the case.
So, why are the pundits fooled? Well, it is because the Breakeven Inflation chart is based on CPI!
We can see that this CPI chart, showing rate of change of inflation including food and energy showed a big spike. But it is an illusion if we listen to the Fed. The Breakeven chart shown below is based on this illusion:
Tips are based upon the Breakeven chart. People saw a spike in CPI inflation coming in 2016, thinking it would continue. But in fact, the Breakeven chart, according to Dr Williamson, is biased upward. Inflation has not reached its target much.
In 2016, as we see from the FRED chart below, PCE, the aqua colored line, climbed slowly, but diverged from CPI, the blue colored line, which exploded upward.
Core inflation peaked at almost 3 percent while PEC topped out just above 2 percent. People staked their reputations and put their money on the bet inflation would explode. If you were on the burning platform pictured at the Burning Platform blog, well, you got burned.
