The St. Louis Federal Reserve's article, "What Do Components of Key Inflation Measures Say about Future Inflation?" delves into the significance of various elements within the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) as indicators of future inflation.
The piece distinguishes between "headline" and "core" inflation. The former is a comprehensive measure that includes a weighted assortment of goods and services from all household spending categories. The latter, on the other hand, omits food and energy, primarily due to their price volatility.
The article refers back to a 2011 study by Michael McCracken that scrutinized the signal-to-noise ratio (SNR) of select CPI inflation components. The SNR gauges the predictive value of a component in relation to its variance, with a lower SNR indicating less predictive utility for future inflation, and vice versa.
The updated analysis reveals an uptick in the SNR of food prices, implying that food expenditures could serve as a valuable indicator of future headline inflation. In fact, food now boasts the highest SNR among all CPI components, closely followed by health care. This indicates that food and health care hold the most predictive value relative to noise.
When it comes to PCE inflation components, the SNR of food services is approximately triple that of food purchases, suggesting that food services, in particular, play a crucial role in forecasting future headline inflation. The SNR of health care outstrips all other PCE components, reinforcing its escalating predictive importance as observed with CPI.
In conclusion, the article posits that despite the excessive volatility of energy prices rendering them unsuitable as predictors, food prices—especially food services—and health care have proven to be effective in forecasting future inflation.
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