Despite declining energy and commodity prices and cheaper imports due to the strong dollar, the current inflation environment is not far off from the Fed's 2-percent target. Most consumer spending is in domestic services and housing — sectors relatively little impacted by currency or oil prices. Moreover, health care and housing prices have been accelerating over the past year. (Incidentally, the CPI weighs housing and health care much more heavily than PCE, which is the main reason why the two measures have diverged so much in recent months.)
So, what do we then make of the deviation between market-based inflation expectations and actual observed prices in recent months? And what does the data tell us about inflation in the future?
First, we should take reports of very low and falling market-based inflation expectations with a grain of salt. The gap between regular bonds and inflation-indexed bonds can often be distorted by extraneous factors, especially during times of market turbulence. The Great Recession offers a case in point; in November 2008, five-year inflation expectations reached a low of -2.2 percent, which clearly turned out to be far below reality.
That said, inflation is likely to remain low through 2016, with core PCE probably remaining below 2 percent (although the core CPI is above two percent).
Several reasons are behind this: First, wages are only just beginning to accelerate and their impact will remain limited this year. Second, the ripple effects of lower oil and commodity prices are still moving through the supply chain, putting downward pressure on consumer prices. Third, the strengthening dollar is likewise still not fully reflected in consumer prices.