US CPI growth slowed down, staying above the target of 2 percent for the second consecutive month, as was shown by data on Wednesday. The headline reading increased by 2.8 percent, while the base figure, which excludes fuel and food, was at 2.2 percent.

The Ministry of Labor published a price report the day before the start of the two-day FOMC meeting on Wednesday. The improvement in employment and inflation rates is expected to allow the regulator to raise rates for the second time this year.

Inflation for several months is above the target level of 2%, but it appears that the Fed is not in a hurry to put pressure on the brake pedal. Such stance relates to the fact that the «inflation overshooting» is possibly not the feature of boom economy cycle, but the impact caused by some exogenous factors, for example, fiscal expansion measures, tax reform, increase in external demand and exchange rate changes. Since the positive impact of these factors hides the ability of the economy to rely on “its own forces,” the Fed is trying to identify the main trend of inflation, which reflects positive shifts in the consumption of investment activity. In addition, because of the increased threat of a reduction in the US trade with its partners, leaving economy without stimulus means accepting the risk of retreat later, especially if the trade threat is realized, so it is impossible to overturn the version that the Fed is trying to put into action more slowly, so as not to leave the main risks to trail behind.

In April, part of the inflation in the US economy was accounted by the dollar growth, which sharply strengthened in March and April, reducing the cost of imports and affecting the cost of the consumer basket. However, in May the exchange rate levelled off and therefore had low impact on inflation. The oil market has also abandoned the idea of renewing peaks due to signs of a change in the OPEC position, so stagnation of oil prices deprives inflation of another catalyst – energy prices.

Compared to the previous month, CPI was 0.2% higher, with food prices remaining unchanged. In April, the dynamics were about the same. In annual terms, the overall price level increased by 2.8%, a figure which economists hadn’t seen in more than six years. This year, the calculation formula included medical services and mobile operators’ plans, which also made a sizable contribution to the price spike.

Apart from fuel and food prices, the monthly inflation rate was 0.2% compared to 0.1% in April. Increased demand here felt the dealers offering new cars, as well as companies in the health sector. Medical services for several months in a row have been leaders in price increases, as the “fee” for being healthy is less elastic to demand, so here companies are usually more confident. In addition, as will be shown below, consumption of some household goods is not accompanied by a corresponding increase in expenditures, i.е. the cause-effect relationship “costs – inflation” appears to not be working as anticipated.

In the absence of an expansion of the money supply (and the Fed’s tightening of its monetary policy), inflation may reflect an increase in costs for the production of goods or the reaction of firms to increased demand for goods. However, firms can misperceive market signals and therefore, they might raise the price of a particular product so high that this will entail a reduction in the total expenditure in the economy for that commodity. In other words, if the price increment (%) causes a greater reduction in demand for goods (%), then its total consumption will fall. That is, we observe inflation in CPI, but there is no corresponding growth in consumption. CPI can still be called an indicator of inflation for those goods which are assumed to be consumed by households, but not actually consumed.

Therefore, the Fed bases its policy on inflation, which reflects the real expenses of consumers, i.e. Core PCE. They also differ in that the weights in the CPI consumer basket change every few years, while in the PCE the weights in the consumer basket change every month. As a consequence, it is possible to trace through PCE how the proportions of consumption between expensive goods and ordinary goods happen, i.e. trace how wealth impacts consumer behavior. The welfare effect is tracked better through the last indicator. That’s why the Fed is interested in what consumers spent, i.e. firms sold and therefore PCE is a better indicator of inflation in a sense. Core PCE, in contrast to CPI, is still below the target level of 2%.

As it is mentioned above, the PCE and CPI indicators differ in the choice of weights in the calculation, reflecting the presence of each product in the basket. CPI includes goods that households consume in a significant amount (for example, health insurance), but do not pay for it directly, as the government pays for it. Thus, in CPI the weight of this product will be higher, but the consumer’s costs will not be reflected

A systematic overestimation of inflation by CPI is of course taken into account by the market, but convergence of those two key measures -where goods which weigh in CPI are smaller, but higher in PCE- will be a very good signal that reflects the acceleration of growth for their demand, i.e. greater inflation, compared with what consumers do not actually spend. What we are now observing in the US:

A good picture in consumption allows expecting more confident comments from the Fed on the policy in the second quarter of 2018.

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