Key insights
- San Francisco Fed researchers suggest the stock market's impact on 'nonmarket' components of PCE inflation, specifically portfolio management fees, may be artificially inflating the overall PCE reading. This could lead the Fed to maintain higher interest rates longer than necessary, potentially hindering economic growth. If the Fed were to focus solely on directly measured prices, inflation might appear lower, potentially prompting earlier rate cuts.
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We all know gas, groceries, and utility bills have been keeping inflation a little too hot for comfort lately. It also turns out the stock market has been providing a sneaky boost to inflation as it's commonly measured.
That's according to an analysis by researchers at the Federal Reserve Bank of San Francisco, who looked at the role of financial markets in the Personal Consumption Expenditures inflation gauge. That benchmark is preferred by Federal Reserve policymakers when evaluating whether inflation is at its 2% annual target.
As of January, PCE inflation increased 2.8% over the year and has been more than 2% since 2021. However, that would likely be much less—possibly leading the Fed to cut its influential interest rate—if not for a quirk of how PCE is measured.
Government statistical agencies like the Bureau of Economic Analysis, which publishes the PCE price index, measure inflation by having agents go out and look at prices for the things people buy, such as clothes, car insurance and plane tickets. Those "market prices" account for most, but not all, of the index.
Some expenses are a bit harder to measure, including portfolio management fees and other financial services. The government "imputes" or estimates these prices. Because portfolio fees are often based on performance, they rise when the stock market goes up.
If the Fed judged inflation only by prices it could actually measure, the inflation rate would look much lower, possibly leading the central bank to keep interest rates lower and providing a boost to the economy.
These "nonmarket" prices have accounted for an increasing share of PCE inflation in recent years, the Fed researchers found. And with stocks hitting record highs regularly over the past two years, they've contributed a surprising amount to the PCE index, possibly giving an impression that inflation is higher than it really is.
Over the last two years, 0.7 percentage points of annual PCE inflation has been due to financial fees and other nonmarket prices, the San Francisco Fed researchers led by director of economic research Sylvain Leduc found.
If you calculated inflation without those nonmarket prices, it would be much closer to the Fed's 2% annual target. That has implications for how the Fed manages its monetary policy.
In recent months, the Fed has kept the federal funds rate higher for longer, pushing up borrowing costs across all kinds of loans to discourage spending and stifle inflation. Under one common inflation-targeting framework, the Taylor Rule, the Fed would be expected to have its key interest rate 0.4 percentage points lower than it is now if it ignored nonmarket prices, the San Francisco Fed researchers found.
"Because imputing prices that cannot be directly observed introduces uncertainty in inflation measures, one approach to monetary policy would be to focus on prices that are directly observed," they wrote. "Under a well-known monetary policy rule, such an approach suggests a notably lower federal funds rate. However, approaches that implicitly account for the uncertainty that policymakers face would leave the federal funds rate essentially unchanged."