Wash rewrites "the Fed's favorite inflation gauge": Will the 2021 "underestimation of inflation" be repeated?

The new Chairman of the Federal Reserve, Waller, is attempting to shift the central bank's policy anchor toward a more moderate alternative inflation indicator. This major underlying framework change has triggered market concerns that the Fed may repeat the mistakes of 2021 and again underestimate potential price pressures.

Current inflation data presents two sharply contrasting faces. According to the latest figures released by the US Department of Commerce, after excluding volatile food and energy items, the traditional core PCE has risen to 3.3% over the past year, marking the fastest increase since 2023. However, as previously mentioned by Wallstreetcn, the Dallas Fed’s trimmed mean PCE inflation rate was only 2.3% year-on-year in April.

Nick Timiraos, a Wall Street Journal reporter known as the Fed’s mouthpiece, pointed out in a recent article that this statistical divergence directly affects the Fed’s interest rate path and the market’s expectations for rate cuts. Waller clearly preferred the trimmed mean PCE at his confirmation hearing in April, believing it better filters out one-off shocks such as tariffs and geopolitical events, thereby supporting the dovish narrative that inflation is improving. In contrast, Fed Governor Lisa Cook has publicly warned that the core inflation indicator is "clearly moving in the wrong direction."

For investors, the focus now is on which inflation thermometer the Fed should trust. If the policy framework led by Waller grants greater weight to the trimmed mean PCE, the logic of maintaining easy policy or rate cuts in the short term will be strengthened; but if the indicator currently contains systematic bias, this "false sense of security" may cause the Fed to fall behind the inflation curve again.

Core Disagreement: Cooler Alternative Indicators to Hedge Traditional Inflation Worries

For a long time, the CPI released by the US Department of Labor has drawn public attention due to its early release date and linkage to numerous contracts, but Fed policymakers see more importance in the Commerce Department’s PCE price index, especially core PCE. However, Waller referred to core PCE as a "rough swag," believing it retains too many one-off price distortions.

The Dallas Fed's trimmed mean PCE favored by Waller attempts to eliminate noise through a systematic filtering mechanism. Unlike the core PCE, which consistently excludes food and energy, this indicator removes the largest increases and decreases each month depending on price changes and retains the middle portion. According to Dallas Fed researchers, in April the trimmed mean inflation was 0.7 percentage points lower than core PCE, mainly because this indicator reduces the weights of goods directly affected by tariffs.

In Waller’s view, current tariff policies, the AI investment boom, and price increases due to geopolitical shocks are short-term phenomena to "look through" and should not prompt policy tightening. Consistently lower readings from the trimmed mean PCE provide direct data support for this policy stance.

Design Flaws: The Hidden Danger of Repeating the 2021 Mistake

Historically, the Dallas Fed's trimmed mean PCE has had a good forecasting track record, but its performance during the inflation surge in 2021 has raised widespread doubts. At that time, as inflation climbed sharply, the indicator showed much slower inflation growth than reality, and even became an argument for policymakers to see inflation as "temporary."

The root cause of this mistake lies in the indicator’s underlying design. Between 1977 and 2009, US price decreases were generally bigger than increases. To eliminate upward bias from this skewed distribution, the Dallas Fed’s indicator excludes the largest 31% price increases in a given month but only eliminates the largest 24% decreases.

However, in 2021 after the pandemic, historical patterns reversed, and price increases began to exceed decreases. By mechanically removing more items with large price rises, the Dallas Fed’s index inadvertently underestimated the actual upward inflation trend. Now, similar divergences are appearing again, prompting discussion on whether the indicator is failing once more.

Bias and Underestimation: How High Is True Inflation?

Facing the widening data gap again, both research institutions and within the Fed have issued warning signals.

Dallas Fed economist Tyler Atkinson cautioned against excessive optimism from the current trimmed mean PCE level. He pointed out that tariffs imposed by the Trump administration pushed up the prices of many goods, so price increases are now spread across more goods, which makes the current trimming rules possibly exclude too many high-inflation items.

Nomura further quantified this bias in a recent research report. Nomura noted that after the pandemic, core goods prices no longer consistently provide disinflationary forces; the AI investment boom’s demand for computing and software, along with more frequent corporate price adjustments, has led the distribution of price changes to more easily skew right. After bias adjustment, the current trimmed mean inflation is about 2.8%, meaning the official indicator may underestimate underlying inflation by about 48 basis points.

Left-wing think tank Employ America’s data likewise confirms this underestimation. The think tank’s symmetric trimmed PCE indicator (i.e., removing the same proportion from both the top and bottom of the distribution) reached 3% in April, significantly narrowing the gap with core PCE. Another indicator that excludes housing and imputed prices recorded 2.8% in April, and has risen year-on-year for thirteen consecutive months.

Market Impact: Policy Framework Reshaping and Risks of Lagging the Curve

Timiraos stated in his article that Waller’s adjustment of inflation indicator preference is essentially a reshaping of the Fed’s framework to cope with a new era of price shocks.

Former Fed economist and head of an inflation research company, Riccardo Trezzi, bluntly pointed out that the key is whether “looking through” price volatility is fundamentally a principled policy framework, or just a tool to downplay inconvenient inflation data when needed. Trezzi emphasized that as the entire price distribution has shifted upward recently, the evidence that inflation has not improved remains strong.

Other market institutions are similarly skeptical of the cooling signal released by the trimmed mean PCE.

Standard Chartered Bank analysts Steve Englander and Dan Pan think that historically, this indicator’s ability to predict future inflation is inferior to core PCE, and it's difficult to prove that its current anti-inflation trend is genuine. Harvard economist Jason Furman also expressed concern, noting that while referencing alternative indicators is not unreasonable in itself, the real risk is whether these indicators are picked after the fact to suit specific policy preferences.

For financial markets, this shift means the narrative for rate cuts gains more favorable data in the short term. If these price shocks are indeed one-off factors, the trimmed mean PCE will give the Fed a reason to avoid tightening; but if these alternative indicators obscure broader demand pressures and structural inflation, relying too heavily on them will provide false reassurance and could force the Fed to take more aggressive tightening actions in the future.

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