Alternative Inflation Indicators Show Price Pressures at Lowest Levels Since Early Pandemic

While headline inflation remains stubbornly above the Federal Reserve's 2 percent target, a set of alternative measures that strip out volatile price swings suggests underlying inflation has fallen to its lowest level in years. The Dallas Fed's trimmed mean inflation measure dropped to just 1.4 percent on a one-month annualized basis in June, the lowest reading since November 2020.

The trimmed mean approach works like a teacher grading on a curve. The Dallas Fed's version excludes the 24 percent of items with the lowest price changes and the 31 percent with the highest changes, aiming to capture where most consumer prices are actually trending. On a 12-month basis, the Dallas trimmed mean fell to 2.2 percent in June, down two-tenths of a percentage point from May and the lowest since July 2021.

Fed Chairman Kevin Warsh, who took the helm earlier this year, has signaled he plans to reexamine how the central bank views inflation and what data points it employs. These trimmed mean measures could take on new prominence under his leadership as policymakers search for clearer signals amid conflicting economic data.

Two Competing Pictures of Inflation

The divergence between traditional and trimmed measures has created a puzzle for Fed officials. The Commerce Department reported Thursday that the personal consumption expenditures price index, the Fed's primary inflation tool, fell 0.1 percent in June largely due to declining fuel costs. But the core measure, which excludes food and energy, rose 0.1 percent. On an annual basis, headline PCE inflation stood at 3.7 percent while core PCE registered 3.3 percent.

Citigroup economist Andrew Hollenhorst argued in a recent note that the trimmed mean data "should also now fall closer to target-consistent rates." He added that the fact underlying inflation continues slowing toward the Fed's 2 percent goal across a broad set of indicators is particularly relevant given Chairman Warsh's stated intention to analyze inflationary pressure through multiple lenses.

The Cleveland Fed offers its own trimmed mean measure using the consumer price index as a benchmark. That gauge, which excludes price changes below the 92nd percentile and above the 8th percentile, showed a June reading of 2.63 percent, the lowest since May 2021 on an unrounded basis.

Skepticism and Caveats

Not everyone is convinced the trimmed mean measures paint an accurate picture. Dallas Fed President Lorie Logan, who oversees her bank's trimmed mean calculation, has cautioned against reading too much into recent declines. She noted that researchers have found compositional factors are causing the trimmed mean to drop too many price increases right now, potentially making the measure lower than the true inflation trend.

The debate comes as the Fed faces mounting pressure to take action on inflation. Several Fed officials who voted to raise interest rates at recent meetings have publicly argued that the current policy stance may not be restrictive enough to bring inflation fully under control. The June economic projections showed nine policymakers favoring rate hikes and nine supporting holds or cuts, revealing deep divisions within the Federal Open Market Committee.

Fed Governor Christopher Waller recently warned that inflation remains the primary risk facing the economy and put a July rate hike on the table. San Francisco Fed President Mary Daly and Kansas City Fed President Jeffrey Schmid have both delivered speeches in recent weeks emphasizing that inflation has stayed too hot for too long, well above the Fed's 2 percent target.

Markets Await More Data

Hollenhorst expects financial markets to price out rate hikes in the coming months as inflation data continues to improve. He also noted that markets could begin pricing in rate cuts if the unemployment rate rises as Citigroup projects. The next major inflation report will arrive in mid-August with July CPI data, giving policymakers additional information before their September meeting.

For now, the competing inflation narratives leave the Fed in a challenging position. Traditional measures suggest inflation remains a serious problem requiring sustained tight monetary policy. Trimmed mean indicators point to underlying price pressures that have already cooled significantly. Chairman Warsh's willingness to consider a broader range of metrics may determine which story ultimately guides Fed policy in the months ahead.