Confused about what’s causing inflation? This metric shows what’s driving the price rise.

On Friday, the Commerce Department released PCE data for January that showed a 5.4% year-over-year increase in prices, a higher rate than the 5.3% PCE year-over-year increase in December. The new PCE figures caused the U.S. stock market to drop another leg down, and pushed government bond yields higher. 

Because PCE has emerged as such a crucial measure for policymakers and investors, economists like to slice and dice the numbers behind the headline figure to better gauge what is going on in the economy. For example, Adam Shapiro at the San Francisco Federal Reserve Bank categorizes the change in prices of PCE’s underlying components and measures to what degree they are being affected by supply-side issues or demand pressures. After all, the economy is a combination of sectors that all behave differently and react to different factors. 

“Economists have always isolated certain sectors or certain categories, and the most basic example is core inflation,” Shapiro said. “Core just strips out two broad categories — food and energy — with the assumption that those two categories are really volatile and they cloud the underlying picture of inflation.”

Making specific assumptions, like the decision to strip out food and energy, are the key to answering different, targeted questions about which areas of the economy should be examined closer. Shapiro each month drills down on different components and then categorizes what is driving the price change of those components. Shapiro publishes Supply- and Demand-Driven PCE Inflation each month to inform policymakers and the public how much overall inflation is impacted by either supply or demand shocks — each of which call for different responses.

Deciding which bucket – supply or demand – to put each component into is determined by the principles of economics 101. If the price of used automobiles, say, is up and quantity is down, there is a supply issue. If prices are up and quantity is up, Shapiro concludes there is a demand issue.

According to Shapiro’s work, inflation for components categorized as supply-driven for the month of December amounted to 2.3% and for demand components 1.7%. Components that are not clearly affected by either supply or demand are categorized as ambiguous and given their own inflation number, December was 0.9%. The total of these equal 5.0%, the previous reading for December before Friday’s revision.

This sort of assessment can guide policymakers.  For example, the Federal Reserve’s monetary policy of interest rate setting can be a tool for reining in inflation, by influencing consumers’ desire to spend. This policy move, however, does less when it comes to supply-side issues.

Supply issues could emerge due to labor shortages. Demand issues are caused by consumers increasing their spending on products and services.  By grouping PCE components into “supply” and “demand” buckets, the story of this two-year inflation cycle can be better understood. From Shapiro’s work, it’s clear that much of the inflation story has come from supply-side constraints, even in recent months.

The rise in prices has been driven by both supply-side and demand factors 

Drilling down on PCE’s components shows that half of the inflation-measure’s rise in the last year has been supply-driven; one-third is demand.

Shapiro hopes that his data crunching can provide a better statistical understanding of the prices of goods and services.

“I think what the series is actually most beneficial at is it helps tell the story of how the supply and demand shocks have evolved over the pandemic and that it’s not just one or the other,” Shapiro said. “It’s actually a confluence of both of them happening, but it’s just the timing of them varies a lot.”