For release on delivery
10:30 a.m. EST
February 27, 2023
Recent Inflation and the Dual Mandate
Remarks by
Philip N. Jefferson
Member
Board of Governors of the Federal Reserve System
at the
Ec10, Principles of Economics, Lecture
Faculty of Arts and Sciences, Harvard University
Cambridge, Massachusetts
February 27, 2023
Thank you, Jason, for inviting me to join your economics class and for your kind
introduction. It is a pleasure to be here. I miss teaching economics classes.
Before I continue, I would like to note, as I always do, that the views I will express today
are my own and are not necessarily those of my colleagues at the Board of Governors of the
Federal Reserve System or the Federal Open Market Committee (the FOMC).
What I like about economics is that it deals with real-world issues, and many times we
experience firsthand a topic discussed in textbooks. Take the recent inflation, for example. This
may be your first experience with high inflation. I am sure you noticed prices going up at
restaurants, supermarkets, and the gas pump without having to read about it in the newspaper. I,
for one, can confirm that the inflationary pressure in the rental housing market in the
Washington, D.C., area is real. While we have all experienced prices going up, it's challenging
to measure inflation itself and its consequences.
Today, I want to do the following: discuss with you different ways to measure inflation,
characterize our recent inflation, and contextualize the battle against inflation in terms of the
Fed's dual-mandate goals of price stability and maximum employment. Then, I will offer some
concluding remarks.
Different Ways to Measure Inflation
The two primary measures of the price level in the United States are the consumer price
index, commonly referred to as the CPI, and the personal consumption expenditures price index,
commonly referred to as the PCE price index. Positive changes in these indexes are recorded as
inflation. Each inflation measure has both total (or headline) and core subindexes, which I will
talk about later. The CPI and PCE price indexes are constructed in broadly similar ways, but
there are important differences between them.1 Both indexes measure inflation using a specific
basket of goods and services consumed by households. These baskets are similar but not
identical across the two measures. Both measures also weight each item in their basket roughly
in accordance with its expenditure share. That is, the more households spend on an item, like
rent, the higher the weight it receives in the overall index. The weights are broadly similar
across the two indexes, but, again, there are some important differences.
Now, let's talk in more detail about the differences between the CPI and the PCE price
indexes. First, the PCE price index has a broader scope than the CPI. The CPI is limited to
expenditures that households pay out of pocket, while the PCE price index covers a broader set
of goods and services as it seeks to cover prices for all consumer expenditures in the national
income and product accounts (NIPA). For example, the PCE price index includes prices of the
health services provided to households through Medicaid, while the CPI excludes these items.
Second, the PCE price index and the CPI use different weighting systems. The PCE price
index, which is more comprehensive than the CPI, estimates expenditure shares using the
national income and product accounts, while the CPI measures expenditure shares using a
separate survey of households, the Consumer Expenditure Survey. This leads to some
differences in expenditure weights that can at times be important. For example, the share of
medical services is notably higher in the PCE price index (partly because the PCE price index
includes more kinds of medical expenditures), and the share of housing services is noticeably
smaller (because overall expenditures are larger in the PCE price index). As a result, when
1
See, for example, Johnson (2017), who explains methodological similarities and differences between PCE price
index and CPI.
health-care services or housing services inflation behave differently than other prices, this can
lead to differences in PCE versus CPI inflation.
Another difference in the weights is that the PCE price index uses time-varying weights,
while the official CPI keeps weights fixed for a year. The PCE price index weights change to
reflect changes in the goods consumers buy. For instance, at the start of the pandemic, the CPI
was still giving the same weights to cruise ship and airline fares, even though no one was
traveling. The time-varying weights in PCE also account for substitution behavior. Suppose the
price of apples goes up and the price of oranges stays the same. Consumers are then likely to
substitute apples with oranges. In contrast, the CPI does not capture substitution behavior
because the basket of goods consumers purchase is updated only once a year (instead of every
month) and reflects expenditure patterns prevailing two years ago. The substitution effects
captured by the PCE price index is one reason why PCE inflation (black line) is, almost always,
lower than CPI inflation (red line), as you can see in figure 1.
As I mentioned earlier, there are both total and core PCE price and CPI indexes. The
core subindex is the total index excluding food and energy prices.2 Food and energy prices are
more volatile than other prices, which makes total inflation more volatile.
This volatility is evident in figure 2. You can see the black line (total PCE price index)
exhibiting more drastic ups and downs than core PCE price index, the red line in the graph, and
many of the sharp movements are short lived. In other words, the volatility in the total PCE
price index makes it harder to discern trends (longer-lasting movements) from transitory
movements. In addition, food and energy prices often depend on factors that are beyond the
influence of monetary policy, such as geopolitical developments (for example, those associated
with fluctuations in energy prices) or weather or disease or war (for example, in the case of food
prices).
In summary, the differences between CPI and PCE price indexes are important. The
FOMC has chosen to target the PCE price index because it is broader and it captures more
accurately what households are actually consuming.3 In addition, food and energy account for a
significant portion of household budgets, so the Federal Reserve's inflation objective is defined
in terms of the total PCE price index, but the Fed monitors the core PCE price index, as well as
other inflation indicators, in order to identify evolving inflation trends.4
Select Components of Core PCE Inflation
Now, I would like to dig a bit deeper into recent inflation trends. To do so, I find it
useful to look at three large categories that together make up the core PCE price index: goods
excluding food and energy, housing services, and services excluding housing and energy. Slide
7 provides some examples of what is in each subcomponent.
Figure 3 shows recent inflation rates for each component: goods excluding food and
energy (black line), housing services (blue line), and services excluding housing and energy (red
line). I look at these three categories separately because what has been causing inflation in each
of these sectors is somewhat different. Understanding the different causes and how they affect
the different components could help the FOMC predict the future course of inflation. Since
monetary policy affects the economy (and inflation) with a lag, the Committee is always forward
looking.
Focusing on the price of core goods, the black line in figure 3, you can see how goods
prices rose sharply in the second half of 2020 due to both a rapid shift in demand toward goods
and unprecedented disruptions to global supply chains. As so many were isolating themselves-
especially those of us lucky enough to have jobs that let us work remotely-there was a sharp
shift in demand from services (eating out and traveling) to durable goods (like stationary
bicycles) to make our stay-at-home experience more pleasant. The pandemic also severely
disrupted the global production and distribution of goods, leading to large backlogs at ports and
widespread shortages of materials, most notably semiconductors. The imbalance between supply
and demand for goods resulted in a sharp increase of prices. At the end of 2021, once vaccines
were developed and deployed and people slowly emerged from isolation, there was a partial shift
in demand back to services, and supply chain bottlenecks started to ease. Thus, inflation in this
category started to come down and has come down substantially.
In contrast to core goods, housing services inflation, the blue dashed line in figure 3, has
not started to come down yet. Housing services prices are estimated using information on rents
and measure the price that renters pay, and homeowners would pay, to live in their homes. Like
core goods, demand in the housing sector underwent a major shift during the pandemic.
The surge in work from home shown in figure 4 led to an increase in the demand for
bigger homes located in smaller metro areas or further from city centers. These shifts in demand
happened much more rapidly than the response in housing supply. As a result, rents increased
quite significantly.
We have not seen a decline in housing services inflation, but there are indications that we
soon will. To see this, consider figure 5. Because rental agreements tend to be renewed
infrequently (often only once a year), average rents (the black line), which is what the PCE price
index measures, tend to lag market rents (the green, blue, and red lines), the rent I would pay if I
were to sign a new lease as a new tenant. For this reason, market rents are a leading indicator of
how overall rents and housing services prices are likely to change over the next 6 to 12 months.
Market rents are now increasing much more slowly than over 2021 and much of 2022,
suggesting that housing services inflation will eventually slow.
Lastly, inflation in other core services, the red line back in figure 3, is a large category
that covers activities as varied as travel and recreation, and medical and legal services. Inflation
for these services has remained stubbornly high. As other Governors and I have noted in the
past, an important source of inflation pressures in this category has likely been the shortage of
workers, which has pushed up labor costs at rates above those consistent with 2 percent inflation.
The inflation outlook for this nonhousing category of core services partly depends on whether
growth in nominal labor costs comes back down, and recent data suggest that labor
compensation has indeed started to decelerate somewhat over the past year.
Although I have focused on core inflation because it is more useful for assessing trends in
inflation, we also closely follow food and energy prices given that our target is for total inflation
and that food and energy prices are very important for many households. Both food and energy
inflation rose sharply following the Russian invasion of Ukraine. But more recently, food
inflation has slowed somewhat, as global food prices have retraced some of their earlier
increases, while energy prices have fallen noticeably. Because energy prices are shaped
primarily by global developments and not by U.S. monetary policy, there is a lot of uncertainty
about the future course of energy inflation.
In summary, core goods inflation has started to come down. Several indicators suggest
that housing services inflation is likely to come down in the coming months. There is more
uncertainty surrounding inflation in core services excluding housing. Over time, we'll learn
more about inflation dynamics in this sector.
Benefits of Price Stability and a Target of 2 Percent
So far, I've talked about how to measure inflation, about different subcomponents, and
about drivers of inflation. I will now discuss the benefits of price stability and a longer-run 2
percent inflation rate target.
Price stability is one of two goals assigned to the Federal Reserve by law, but there is also
a broad consensus among economic researchers and policymakers that price stability is a
desirable objective. Deviations from price stability in the form of persistently elevated inflation
rates are costly for the economy for several reasons, some of which I'll review now.5
Fundamentally, a low and stable inflation rate is beneficial for the decisionmaking
processes of households and firms. Choices regarding work, savings, and the expansion of
business enterprises are likely to be harder when there is uncertainty about the likely future
course of prices. Retirement planning by households and investment decisions by firms are,
consequently, put on a sounder footing if there is confidence about the future value of the
currency. The avoidance of this uncertainty is also likely to be beneficial for national economic
performance. If the prospect of high inflation or uncertainty about future inflation factors
heavily into firms' and households' calculations, it is less likely that resources will be allocated
to activities that raise the productive potential of the economy, rather than into areas that are only
made attractive by the presence of high and variable inflation.6
There are other economic costs of high inflation. In the labor market, as nominal wages
are often set in advance, bouts of unanticipated inflation typically lead to a drop in workers' real
wages in the short run, and this is a burden on households in meeting their expenses.7
More generally, even anticipated rates of inflation can produce redistributions of income.
Such redistributions are also likely to be adverse for members of society who do not have ready
access to the kinds of financial instruments that would best protect them against high inflation.
The likelihood of wide-ranging distortions due to inflation is enhanced by the fact that the
U.S. tax code does not fully take inflation into account. Consequently, as stressed in
fundamental work by the late Martin Feldstein of Harvard University, high inflation can distort
saving and investment decisions, including through the treatment of after-tax capital gains.8
Another reason why deviations from price stability distort decisions and redistribute
income lies in the fact that much of our financial system, including many arrangements
pertaining to retirement plans, is structured in terms of streams of nominal payments.9 Absent a
background of a steady and predictable inflation rate, the purchasing power of retirement income
streams and other payments may turn out to be very different from what was envisioned when
they were originally arranged.
The fact that much of the financial system is based on nominal payments also makes it
clear that unexpectedly or unduly low inflation rates have important economic costs, too,
including by saddling borrowers (debtors) with very high repayment burdens in real terms.
Consider homeowners who take out a conventional fixed-rate mortgage, with the expectation
their nominal incomes will rise about 2 percent per year. If the economy were instead to
experience deflation accompanied by flat or declining wages, then after a few years the
homeowners might find it considerably more difficult to cover their monthly fixed mortgage
payments than they had originally anticipated. This increase in the real value of debts due to
very low inflation or, worse, outright deflation would also be a burden on all households that
have outstanding fixed nominal student loans, auto loans, or credit card debt, as well as
businesses that had taken out bank loans or issued bonds.
In 2012, the FOMC set a formal inflation target to help households and businesses
understand our goal and help keep inflation expectations anchored over time. The FOMC's
choice of a 2 percent inflation rate, instead of zero, reflected the judgment that reasonable price
stability was desirable while also recognizing the reality that very low inflation can also be
economically costly.10 In addition, a zero percent goal would make the longer-run nominal
interest rate 2 percentage points lower than would be the case under a 2 percent inflation goal. A
zero-inflation environment would consequently restrict the FOMC's scope to lower nominal
interest rates when this was necessary for stabilization purposes. In contrast, a 2 percent
inflation rate is still low enough to be consistent with price stability but gives the FOMC greater
scope to stimulate the economy in times when it judges that achievement of maximum
employment requires that the Committee provide policy accommodation.
From these considerations flows the conclusion that a 2 percent inflation rate is the price-
stability objective most consistent with the FOMC's dual mandate. The 2 percent longer-run
inflation goal has been maintained since 2012.
Policy Risks and the Benefits of Credibility
Often, the FOMC must balance competing risks given its dual mandate of promoting
maximum employment and stable prices. In the current context, there is, on the one hand, the
risk that monetary policy will not be sufficiently restrictive to bring inflation back to 2 percent
over time, and on the other hand there is a risk of policy being too restrictive and unnecessarily
increasing the likelihood of recession. In the face of this latter risk, some economists argue that
a higher inflation target is better than the Fed's current 2 percent target rate.11 Changing the
FOMC's longer-run inflation objective, however, would introduce an additional risk by calling
into question the FOMC's commitment to stabilizing inflation at any level because it might lead
people to suspect that the target could be changed opportunistically in the future. If so, then
these reputational costs will undermine the key benefits of well-anchored longer-run inflation
expectations discussed above: an increased ability of monetary policy to fight economic
downturns without sacrificing price stability. Moreover, if the purpose of a higher inflation
11
See, for example, Summers (1991) and Reifschneider and Williams (2000). Blanchard, Dell'Ariccia, and Mauro
(2010), among others, have suggested that central banks should consider raising their target inflation rate, on the
grounds that conditions since the financial crisis have demonstrated that monetary policy is more constrained by the
effective lower bound (ELB) on nominal interest rates than was originally estimated. Ball (2013), for example, has
proposed 4 percent as a more appropriate target for the FOMC. While it is certainly likely that earlier analyses of
the implications of the ELB significantly underestimated the likelihood of severe recessions and slow recoveries of
the sort recently experienced in the United States and elsewhere (see Chung and others, 2012), it is also the case that
these analyses did not consider central banks' ability to use large-scale asset purchases and other unconventional
tools as a means of providing economic stabilization in the presence of the ELB constraint.
target is to increase the ability of the central bank to deal with the severe recessions that follow
financial crises, then a better strategic approach might be to rely on more vigorous supervisory
and macroprudential policies that could help reduce the likelihood of such events. Further,
seeking an inflation rate in the vicinity of 4 percent or higher would certainly stretch the meaning
of "stable prices" in the Federal Reserve Act.12
Conclusion
In conclusion, today, I have discussed with you how persistently high inflation hurts
everyone and how the Fed must jointly achieve price stability and maximum employment to
fulfill its dual mandate over time. I also discussed how persistently low inflation is costly, and
how changing the 2 percent inflation target would damage the central bank's credibility. For
these reasons, I am committed to lowering inflation to our 2 percent target.
This is a very exciting time to study economics. I hope that the ways of thinking you are
developing in this class will help you better understand economic phenomena that you observe
and the challenges that policymakers face.
Thank you.
12
In rejecting a 4 percent inflation target, Bernanke (2010a) suggests that "inflation would be higher and probably
more volatile under such a policy" and "inflation expectations would also likely become significantly less stable."
According to Bernanke (2010b), "The Federal Reserve over a long period of time has established a great deal of
credibility in terms of keeping inflation low, around 2 percent . . . If we were to go to 4 percent, and say we're going
to 4 percent, we would risk I think losing a lot of that hard-won credibility because folks would say, well, if we go to
4, why not go to 6 . . . It would be very difficult to tie down credible expectations at 4."
References
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Targeting: Lessons from the International Experience. Princeton, N.J.: Princeton
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https://www.imf.org/external/pubs/ft/spn/2010/spn1003.pdf.
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Recent Inflation and the
Dual Mandate
Philip N. Jefferson
Governor, Federal Reserve Board
Ec10 Harvard Lecture, February 27, 2023
Disclaimer: The views I will express today are my own and not necessarily those of the
Federal Open Market Committee (FOMC) or the Federal Reserve System.
Roadmap for the lecture
• Discuss different ways to measure inflation
• Characterize recent inflation
• Contextualize the battle against inflation in
terms of the Fed's dual mandate
• Offer concluding remarks
Two primary measures of inflation
• Consumer price index (CPI)
• Personal consumption expenditure price index
(PCE)
• Both indexes use:
- Price of basket of goods and services
- Weight each item in the basket by expenditure
shares
Differences between two primary
measures of inflation
Consumer Price Index (CPI) Personal Consumption Expenditures
Price Index (PCE)
Narrower scope: Excludes some Broader scope: All consumer expenditures
expenditures like health services paid by
Medicaid
Weight based on consumer expenditure Weight based on expenditure shares using
survey (e.g., expenditure share of housing NIPA (e.g., expenditure share of medical
services is higher than in the PCE) services is higher than in the CPI)
Fixed weights for 1 year reflecting Weights change to reflect changes in the
expenditures from 2 years ago goods consumers buy


Examples of select components of
core PCE inflation
Components of Core PCE Examples
Inflation
Core goods New motor vehicles
Used motor vehicles
Other durable goods
Nondurable goods
Housing services Rent
Core services excluding Airline fares
housing Medical care



Benefits of price stability
• Price stability is one of two goals assigned to the Federal
Reserve by law
• Broad consensus among economists that price stability is a
desirable objective
• Stable inflation means there is low uncertainty about future
course of prices
• Low uncertainty is beneficial for the decisionmaking
processes of households and firms
Unanticipated high inflation is
costly
• High unanticipated inflation lowers workers' real wages
• Even anticipated rates of inflation can produce redistribution
of income
• U.S. tax code does not fully take into account inflation
• Purchasing power of retirement income may be much lower
than anticipated
Unanticipated low inflation is costly
• Low inflation affects borrowers
• Low inflation restricts the FOMC's scope to lower real
interest rates
Policy risks
• The FOMC must balance competing risks given its dual
mandate of promoting maximum employment and stable
prices
• Current environment:
- Risk of policy not being sufficiently restrictive to bring back
inflation to 2 percent over time
- Risk of policy being too restrictive and unnecessarily increasing the
likelihood of recession
• In the face of this latter risk, some economists argue that a
higher inflation target, 3 or 4 percent, is better
Benefits of credibility
• Changing the FOMC's long-run inflation objective would
hurt the FOMC's credibility
•
The effectiveness of monetary policy depends on the
FOMC's credibility
• Benefits of credibility outweigh costs of a 2 percent
inflation target (as opposed to a higher inflation target)
Conclusions
• Persistently high inflation is costly
• Persistently low inflation is costly
•
Changing the 2 percent inflation target would damage the
central bank's credibility, so I am committed to lowering
inflation to our 2 percent target
• Exciting time to study economics