What is keeping core inflation above 2 percent

What is keeping core inflation above 2 percent?

Personal consumption expenditures (PCE) inflation is expected to be 2.7 percent over the 12 months ended in August 2025 and has been above the Federal Open Market Committee's 2 percent target since early 2021. (We estimate August PCE inflation using the August Consumer Price Index and producer price index.)

To better assess the underlying momentum in price changes, volatile items are often omitted from the inflation calculation. Core PCE, which excludes food and energy items, is expected be 2.9 percent in August and has steadied above 2.5 percent since mid-2024.

When thinking about where inflation is headed, it is helpful to consider the inflation rates of different categories within the consumption basket. A common way of categorizing core PCE inflation is by core goods (goods apart from food and energy items), housing services (rent and owner's equivalent rent) and non-housing core services (all services apart from housing and energy services) (Chart 1).

What is the benchmark?

Over the past year, core goods prices have increased around 1.2 percent. They carry a weight of about 30 percent in the overall core PCE basket and have contributed around 0.3 percentage points to core PCE. Housing inflation has been around 3.8 percent, with a weight of around 15 percent and a contribution of around 0.7 percentage points. Non-housing core services prices have increased around 3.3 percent, have a weight of about 55 percent and contributed 1.9 percentage points.

The fact that non-housing core services inflation had the largest contribution over the past 12 months doesn't necessarily mean it is more of a problem than the other categories, since there are typical differences in the inflation rates of the three categories. Those differences are driven by long-run changes in their relative prices.

Goods, for example, have tended to become cheaper relative to services, so core goods inflation has typically run several percentage points below services inflation. Figuring out the degree of "excess" inflation in a given category requires a comparison to a benchmark rate.

Analysts often compare the current contribution of each category to an average over some period to calculate excess contributions. The several years before the pandemic, 2017-19, is a natural benchmark, though actual inflation averaged only 1.7 percent over this period.

A category could contribute 0.3 percentage points above this baseline and still be consistent with 2 percent inflation, as long as the other categories return to their 2017-19 averages. One could pick a period when inflation averaged near 2.0 percent, such as 1989-2019 or 2002-07, but those periods may not be representative of conditions that are likely to hold going forward.

Average relative price changes can point to a benchmark

An alternative approach that doesn't rely on picking a specific period when inflation averaged 2 percent is to consider the behavior of relative prices. Chart 2 plots the gap between non-housing core services inflation and core goods inflation.

Chart 3 plots the gap between housing and core goods.

These gaps are essentially changes in the relative prices of housing and non-housing core services in terms of core goods. Assuming the gaps between these inflation rates will converge to some constants (π^h - π^g = c^hg,π^s - π^g = c^sg) and core inflation (the expenditure-share-weighted average of the three core components) equals 2.0 percent (π = w^gπ^g + w^hπ^h + w^sπ^s = 2) results in a system of three equations in the three unknown inflation rates. The 2.0-percent-consistent rate for each category can then be backed out.

Table 1 shows the average 2.0-percent-core-inflation-consistent rates and excess contributions using various periods over which the relative inflation rates are averaged.

Using the longest average possible of relative price changes, 1960-2025, both core goods and non-housing core services are contributing around 0.3 percentage points above what would be consistent with 2 percent inflation, while housing's excess contribution is around 0.2 percentage points.

Acceleration in prices for core goods this year has been widely attributed to increased tariffs. If tariffs have only a one-time impact on the level of core goods prices, as most forecasters expect, excess inflation from this category can reasonably be expected to fade over the coming couple of years. Similarly, the 0.2 percentage point excess contribution from housing can be expected to fade based on forecasts using market rents that have been reliable in recent years.

If core goods and housing inflation slow as expected, a 0.3-percentage-point excess contribution from non-housing core services would be left. It is less clear that this inflation rate is propped up by temporary factors or set to slow significantly further.

The next three columns in Table 1 consider alternative periods to average the relative price changes. The period 1985-2019 is a common estimation sample as it featured relatively low and less volatile inflation following the disinflation under Federal Reserve Chairman Paul Volcker but before the pandemic shock.

Statistical tests for break points in the relative inflation rates find evidence for a break around 1976 for housing inflation relative to core goods, which can be seen in Chart 3, as well as a break in 2009 for non-housing core services relative to goods. Columns 3 and 4 use the averages only after these periods. The takeaway from all four columns is roughly similar: 0.3 to 0.4 percentage points of excess inflation from non-housing core services.

2002-07 was atypical

The last column considers the 2002-07 period as a benchmark. Some analysts have used this benchmark to calculate excess contributions because core inflation averaged near 2.0 percent over that time. Under this benchmark, primarily core goods are a concern, with non-housing core services inflation already near its 2-percent-consistent pace.

However, the data in Charts 1 and 2 suggest the behavior of relative prices at that time may not be broadly applicable. The 2002-07 period exhibited record low core goods inflation relative to core services inflation (or record high services inflation relative to goods).

Rapid goods deflation was the likely product of strong productivity growth, driven by the information technology revolution as well as globalization. If non-housing core services inflation stabilized around its current pace, core goods prices would need to deflate by around 0.9 percent annually to be consistent with 2 percent inflation. This may not be a reasonable expectation if the forces that pushed down on relative goods prices in 2002-07 are no longer at work.

All 12-month periods can be used as a potential benchmark

Instead of picking a single average for the exercise in Table 1, Chart 4 repeats the calculation of the current excess contribution from non-housing core services inflation for every 12-month period over 1960-2025 and plots the resulting distribution. The median is around 0.3 percentage points. In only around 5 percent of the sample is the excess contribution less than 0, and in only around 10 percent of the sample is it 0.1 percentage points or less. While it is possible that goods and housing inflation could recede enough to reach 2.0 percent without further slowing in non-housing core services, the history of relative prices suggests that is unlikely.

Further slowing in non-housing core services not obvious

Is there anything about the composition of non-housing core services inflation that suggests it may slower further? A common approach is to split out the non-market prices from this category, as they are imputed rather than directly measured, may be less reflective of underlying inflationary pressures and are subject to greater noise than other prices.

One of the most volatile of these prices is portfolio management and investment advice services. Management fees are often based on a percentage of assets under management, so month-to-month swings in stock prices heavily influence this price category and make it very volatile. Chart 5 breaks non-housing core services inflation into market-based categories, portfolio management and investment advice services and all other non-market-based services.

Notably, the inflation rate of the well-measured and less noisy set of prices (market based) has been steady around 3.0 percent since May 2024, with no clear downward momentum. The price index for portfolio management and investment advice services has increased around 12 percent over the past year and contributed around 0.2 percentage points to core PCE inflation. If stock prices flatten over the next year, a meaningful drag on PCE inflation would be implied. However, the increase over the past year isn't far from historical averages, so that drag certainly isn't guaranteed.

The inflation rate of other non-market-based services has slowed over the past year, but it is now roughly in line with its market-based counterpart. Further slowing is unclear.

Inflation could stabilize above 2 percent

Even assuming housing inflation will normalize over the next year-which appears reasonable-and assuming any excess contribution from core goods is driven by a one-time effect from tariffs that will fade over the next couple of years, recent non-housing core services inflation likely exceeds a pace consistent with 2.0 percent core PCE inflation and typical changes in relative prices.

While the scale of that excess contribution isn't huge, likely 0.3 to 0.4 percentage points, it has shown little downward momentum over the past year, implying risk that inflation fails to converge all the way to 2.0 percent. While the excess contribution from non-housing core services could potentially be offset by a relatively fast pace of core goods deflation, as occurred over 2002-07, that was an unusual period of relative price changes. It may not be the norm moving forward.