August PCE inflation comes in lower, but with a twist

• Key insight: The Bureau of Economic Analysis revised how it estimates the cost of certain nonmarket costs, such as fees charged for financial services and insurance products, resulting in a lower overall reading. 
• Expert quote: "As you are probably aware, I don't like throwing out specific categories going into the estimate of PCE inflation, but nonmarket services prices have always been an issue for me, since they are imputed and not actual price changes. So, ignoring this one factor, my take is that underlying inflation is doing better than the core numbers suggest." — Federal Reserve Gov. Christopher Waller
• Forward Look: Several other key economic indicators are due to be released before the next Federal Open Market Committee meeting, including the September jobs report on Friday. 

The Federal Reserve's preferred measure of inflation came in lower for August, but the down shift was due, at least in part, to a change in the index's methodology.

The Bureau of Economic Analysis Wednesday morning reported that the personal consumer expenditure, or PCE, index came in at an annualized rate of 3.4% for August, down 0.3% from July's 3.7% rate. Excluding food and energy costs, the monthly inflation rate was 0.2%, with an annualized inflation rate of 3%. The PCE index is often considered to be the Federal Reserve's preferred measure of inflation and thus one that carries more weight in their monetary policy decisions.

But important changes in the BEA's methodology in compiling its data likely account for some degree of the downward trend.

The BEA said in August that it would revise its methodology in a number of ways, including with updates to the way the agency estimates costs of certain hard-to-price services such as portfolio management, legal services, software and investment advice. Federal Reserve Gov. Christopher Waller had said earlier this month that inflation may actually be lower than markets think because of the outdated ways that certain nonmarket costs are estimated.  

"As you are probably aware, I don't like throwing out specific categories going into the estimate of PCE inflation, but nonmarket services prices have always been an issue for me, since they are imputed and not actual price changes," Waller said. "So, ignoring this one factor, my take is that underlying inflation is doing better than the core numbers suggest."

The inflationary reading, while better than prior months, is still considerably higher than the Fed's 2% inflation target, a target that the Federal Open Market Committee appears eager to meet after overrunning it for the past five years. The FOMC earlier this month raised interest rates for the first time in five years by 25 basis points and indicated that a majority of members expect another rate hike later this year. 

Federal Reserve Bank of New York President John Williams, who serves as a permanent voting member of the FOMC, said at an event in Buffalo Tuesday that he anticipates another rate hike "late this year" to keep tamping down inflation.

"If the economy evolves in a manner broadly consistent with my forecast, one further upward adjustment of the federal funds target range may be appropriate late this year to support a timelier return of inflation to target," Williams said.

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The Fed's stance on interest rates — and its independence to establish those rates — has been a thorny issue between the central bank and the White House throughout President Trump's two nonconsecutive terms. Trump has long said that he believes interest rates should be radically lower than they currently are, and has gone to great lengths to increase his leverage over the board to effectuate that goal. 

Since the swearing in of Fed Chair Kevin Warsh in July, however, Trump has remained more muted in his criticism of the Fed and Warsh, if not resigned to higher rates. White House National Economic Council Director Kevin Hassett said earlier this week that, considering historical correlations between the prevailing inflation rates and interest rates, the current rate would be at the top of the range of normal. Hassett was assuming that inflation is currently reading at 2%, however. 

"If you think that the last three months inflation is running around 2%, and you think that since [the early 19th century] interest rates were about the inflation rate plus two, then you would argue there's not a lot of room to go up from here," he said.