The Fed has an inflation problem because of Obamacare and EpiPens

The Federal Reserve has an inflation conundrum on its hands, and it is due in part to the Affordable Care Act (ACA), better known as Obamacare.

The Fed has a dual mandate to maintain full employment and a sustainable and stable rate of inflation, currently targeted at 2% growth in prices year-over-year.

To measure its progress on that second mandate, the Fed uses core personal consumption expenditures (PCE) inflation which has been running consistently under the 2% target.

While the measure is generally thought of as showing a clear picture of price increases in the US, it is facing a healthcare problem partly brought on by Obamacare.

Core PCE and the other widely-cited measure of inflation, the consumer price index (CPI), use two different methods of tracking healthcare expenses, which we've noted before. CPI tracks only what Americans personally are spending out of pocket on their healthcare, whereas PCE takes into account the insurance costs picked up by the government via Medicaid or Medicare, and the costs private insurers pay.

This difference is a large reason why core PCE and core CPI (both of which strip out volatile energy and food prices) are vastly different. Core CPI is running at a 2.3% increase year-over-year while core PCE is around 1.6%.

According to Paul Ashworth, chief economist at Capital Economics, this presents the Fed with a problem. Using CPI's method of tracking healthcare inflation, core PCE would be at 2.3%, over the Fed's stated target.

The bigger conundrum is that each of the measures, CPI and PCE, are being pulled in opposite directions due to policy impacts on government healthcare and drug pricing. Here's Ashworth's breakdown (emphasis added):

"This represents something of a dilemma for the Fed. After all, the surge in health care insurance premiums, particularly for the new Obamacare plans, and the surge in drugs prices are so severe that they have become legitimate campaign issues in the election. But is that upward pressure on medical care prices a genuine signal of tight economic conditions or is it due to a one-off structural shift? Probably the latter. Similarly, we have argued before that the Fed should ignore the declines in the administered prices set by Congress for Medicare and Medicaid because those are also not a signal of what conditions are like in the market economy."

Put another way, CPI may be too high due to one time spikes in Obamacare premiums and drug prices, but PCE may be too low because of adjustments to costs associated with Medicare and Medicaid.

As Goldman Sachs economists Zach Pandl and Daan Struyven pointed out in a note to clients, the gap between the CPI and PCE healthcare services measures is incredibly wide. Additionally, if you closed that gap to its long-term average there would be a very different picture of inflation.

"Inflation in the CPI for health care services is currently 3pp above the equivalent measure in the PCE deflator-the largest difference since 1961," said the note from Goldman. "If instead this gap were at its 10­ or 20 ­year average, core PCE inflation would be running 0.3pp higher at 1.9%, or core CPI would be running 0.1pp lower at 2.1%."

What is true is that Americans are paying more out of pocket for their medical care than ever before, partially due to the rise of high deductible plans, and drug prices for everything from insulin to EpiPens are skyrocketing. Additionally, the percentage of Americans' income spent on healthcare is increasing.

On the other hand, total healthcare spending in the US is growing at the slowest pace in decades, according to the Kaiser Family Foundation. Also, the shift to high deductible plans has made insurance cheaper for employers, while recent changes to provider reimbursement have dragged down cost increases for private payers.

To Ashworth, this means the Fed will eventually have to recognize the increasing costs of healthcare.

"Underlying inflation is accelerating and the Fed will eventually have to respond," he concluded.

The Goldman economists note that there are some non-policy related factors keeping core PCE inflation low.

"However, health care PCE inflation also looks low for non­policy related reasons, held back by modest inflation in medical care inflation for private payers-a message at odds with the CPI," wrote Pandl and Struyven. "We think reality is somewhere in between, and that health care inflation in the PCE index will pick up, helping narrow the large CPI­-PCE gap."

Either way, the differences between the two measures create a conundrum for Chair Janet Yellen and the Fed.