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Why the Fed’s favorite inflation gauge is much lower than better known CPI

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Inflation is synonymous with the consumer price index, which comes out less than two weeks after the end of each month. But there’s more than one way to measure inflation, and CPI is not the Federal Reserve‘s favorite one.

When Fed Chair Jerome Powell says “My colleagues and I are strongly committed to bringing inflation back down to our 2% goal,” he means personal consumption expenditures price index, which is running roughly two percentage points lower than the consumer price index this year.

What’s the difference between PCE and CPI?

There are three main differences between these two inflation measures. The first difference is where the data comes from. CPI, which is released by the Bureau of Labor Statistics, surveys households to determine consumer prices. PCE, which is released by the Bureau of Economic Analysis, surveys suppliers to find out how much they’re selling and what they’re charging.

“They’re both basically trying to measure the same thing,” Fitch Ratings Chief Economist Brian Coulton said. “They take a basket of goods and services, which is supposed to represent what the typical American household spends their money on, and measures how much the price of buying that basket has gone up.”

But those baskets look a little different, which brings us to the second split, health care and basket weights. CPI looks only at health costs directly drawing from Americans’ wallets, while PCE includes the cost of health care incurred by government programs like Medicare and Medicaid, as well as private insurers.

That difference is evident in the weight of items in each basket. Medical care is a much bigger part of the pie in PCE – 22.3% compared with CPI’s 8.8% – while CPI places enormous weight on housing – 42.1% compared with PCE’s 22.6%.

“The fact that rents are growing more rapidly than underlying inflation as a whole, that’s driving this unusual difference at the moment” Coulton said.

The third major difference is the frequency with which each index adjusts weights in each basket. PCE does a better job capturing real world buying behavior by frequently adjusting weights.

“When the price of say gasoline goes up, or the price of meat goes up, what tends to happen is that consumers, households will spend less on those products, or more on cheaper products,” Coulton explained. “So the weight of say beef would go down if it gets more expensive.”

But the CPI currently only updates weights every two years, so beef might carry more weight than it should, leading to a higher overall inflation rate. Starting in January 2023, the BLS plans to update weights every year instead.

Why is CPI more well known?

“We’ve long used PCE because we think it’s just better at capturing the inflation that people actually face in their lives,” Powell said during a press conference.

Despite its long standing as the Fed’s favorite gauge, Coulton explained why PCE is an after thought for the public.

“I think first mover advantage is a very big deal for the CPI,” he said. “The fact that number comes out first means it gets most of the attention. And the PCE sort of follows up.”

The PCE is usually released about two weeks after the CPI and roughly four weeks after the month it’s measuring, at which point Coulton said the conversation has mostly moved on.

But while the Fed relies on PCE anyway, with the current, stark gap between the two indexes, the Federal Open Market Committee cannot ignore what CPI is telling it on the Fed’s path to 2% inflation. In August, CPI increased at an annual rate of 8.3%, while the PCE price index showed an annual increase of 6.2%.

“If PCE is 2% and the CPI is 2.5%, they’d be quite okay with that because that’s this historical wedge between the two,” Coulton said. “But if it stays at 3-4%, I think they’d be thinking, ‘Well, there’s an element of the inflation process here that has not come back and we need to be cautious about loosening policy too much.'”

Throughout 2022, the Fed has been on a historic, aggressive rate hike campaign in an effort to cool four-decade high inflation, which has in turn pummeled the stock market and created cracks in the unusually strong labor market.

NEWS CLIP: the pce price index as you know has become this favorite gauge of inflation.

NEWS CLIP: the fed’s preferred measure is PCE.

NEWS CLIP: that is the fed’s favorite inflation gauge.

SIMONE DEL ROSARIO: YES THERE’S MORE THAN ONE WAY TO MEASURE INFLATION.

AND THE BETTER KNOWN CONSUMER PRICE INDEX – IS NOT THE FED’S FAVORITE ONE.

SO WHEN FEDERAL RESERVE CHAIR JEROME POWELL SAYS:

JEROME POWELL: my colleagues and I are strongly committed to bringing inflation back down to our 2% goal.

SIMONE DEL ROSARIO: HE MEANS PERSONAL CONSUMPTION EXPENDITURES, WHICH IS RUNNING ROUGHLY 2 POINTS LOWER THAN THE CONSUMER PRICE INDEX THIS YEAR.

SO WHAT’S THE DIFFERENCE BETWEEN PCE AND CPI?

LET’S GET THIS STRAIGHT.

CPI IS CALCULATED SURVEYING HOUSEHOLDS. PCE DATA COMES FROM SURVEYING SUPPLIERS.

FITCH RATINGS CHIEF ECONOMIST BRIAN COULTON: they’re both basically trying to measure the same thing. They take a basket of goods and services, which is supposed to represent what the typical American household spends their money on, and measures how much the price of buying that basket has gone up.

SIMONE DEL ROSARIO: BUT THOSE BASKETS LOOK A LITTLE DIFFERENT. FOR ONE, CPI LOOKS AT HEALTH COSTS DIRECTLY DRAWING FROM AMERICANS’ WALLETS.

WHILE P-C-E INCLUDES THE COST OF HEALTH CARE INCURRED BY GOVERNMENT PROGRAMS, AS WELL AS PRIVATE INSURERS.

THAT DIFFERENCE IS EVIDENT IN THE WEIGHT OF ITEMS IN EACH BASKET.

MEDICAL CARE IS A MUCH BIGGER PART OF THE PIE IN P-C-E…WHILE C-P-I PLACES ENORMOUS WEIGHT ON HOUSING.

BRIAN COULTON: the fact that rents are growing more rapidly than underlying inflation as a whole that’s driving this unusual difference at the moment.

SIMONE DEL ROSARIO: ALONG WITH THIS, PCE CAPTURES REAL WORLD BUYING BEHAVIOR BY FREQUENTLY ADJUSTING THE WEIGHTS IN ITS BASKET.

BRIAN COULTON: when the price of say gasoline goes up, or the price of meat goes up, what tends to happen is that consumers, households will spend less on those products, or more on cheaper products. So the weight of say beef would go down, if it gets more expensive. 

SIMONE DEL ROSARIO: BUT CPI ONLY UPDATES EVERY TWO YEARS – SO BEEF MIGHT CARRY MORE WEIGHT THAN IT SHOULD, LEADING TO A HIGHER OVERALL INFLATION RATE.

JEROME POWELL: we’ve long used PCE because we think it’s just better at capturing the inflation that people actually face in their lives.

SIMONE DEL ROSARIO: SO WHY IS CPI SYNONYMOUS WITH INFLATION – WHEN PCE IS MORE COMPREHENSIVE?

BRIAN COULTON: I think first mover advantage is a very big deal for the CPI. The fact that number comes out first means it gets most of the attention. And the PCE sort of follows up.

SIMONE DEL ROSARIO: BUT WITH THE CURRENT – STARK GAP BETWEEN THE TWO – THE FED CAN’T IGNORE WHAT CPI SAYS ON ITS PATH TO 2%.

BRIAN COULTON: if PCE is two and CPI is two and a half, that’d be quite okay with that, because that’s this historical wedge between the two. But if it stays at three to four, I think there’d be thinking, well, there’s an element of the inflation process here that has not come back. And we need to be cautious about loosening policy too much. 

Inflation is synonymous with the consumer price index, which comes out less than two weeks after the end of each month. But there’s more than one way to measure inflation, and CPI is not the Federal Reserve‘s favorite one.

When Fed Chair Jerome Powell says “My colleagues and I are strongly committed to bringing inflation back down to our 2% goal,” he means personal consumption expenditures price index, which is running roughly two percentage points lower than the consumer price index this year.

What’s the difference between PCE and CPI?

There are three main differences between these two inflation measures. The first difference is where the data comes from. CPI, which is released by the Bureau of Labor Statistics, surveys households to determine consumer prices. PCE, which is released by the Bureau of Economic Analysis, surveys suppliers to find out how much they’re selling and what they’re charging.

“They’re both basically trying to measure the same thing,” Fitch Ratings Chief Economist Brian Coulton said. “They take a basket of goods and services, which is supposed to represent what the typical American household spends their money on, and measures how much the price of buying that basket has gone up.”

But those baskets look a little different, which brings us to the second split, health care and basket weights. CPI looks only at health costs directly drawing from Americans’ wallets, while PCE includes the cost of health care incurred by government programs like Medicare and Medicaid, as well as private insurers.

That difference is evident in the weight of items in each basket. Medical care is a much bigger part of the pie in PCE – 22.3% compared with CPI’s 8.8% – while CPI places enormous weight on housing – 42.1% compared with PCE’s 22.6%.

“The fact that rents are growing more rapidly than underlying inflation as a whole, that’s driving this unusual difference at the moment” Coulton said.

The third major difference is the frequency with which each index adjusts weights in each basket. PCE does a better job capturing real world buying behavior by frequently adjusting weights.

“When the price of say gasoline goes up, or the price of meat goes up, what tends to happen is that consumers, households will spend less on those products, or more on cheaper products,” Coulton explained. “So the weight of say beef would go down if it gets more expensive.”

But the CPI currently only updates weights every two years, so beef might carry more weight than it should, leading to a higher overall inflation rate. Starting in January 2023, the BLS plans to update weights every year instead.

Why is CPI more well known?

“We’ve long used PCE because we think it’s just better at capturing the inflation that people actually face in their lives,” Powell said during a press conference.

Despite its long standing as the Fed’s favorite gauge, Coulton explained why PCE is an after thought for the public.

“I think first mover advantage is a very big deal for the CPI,” he said. “The fact that number comes out first means it gets most of the attention. And the PCE sort of follows up.”

The PCE is usually released about two weeks after the CPI and roughly four weeks after the month it’s measuring, at which point Coulton said the conversation has mostly moved on.

But while the Fed relies on PCE anyway, with the current, stark gap between the two indexes, the Federal Open Market Committee cannot ignore what CPI is telling it on the Fed’s path to 2% inflation. In August, CPI increased at an annual rate of 8.3%, while the PCE price index showed an annual increase of 6.2%.

“If PCE is 2% and the CPI is 2.5%, they’d be quite okay with that because that’s this historical wedge between the two,” Coulton said. “But if it stays at 3-4%, I think they’d be thinking, ‘Well, there’s an element of the inflation process here that has not come back and we need to be cautious about loosening policy too much.'”

Throughout 2022, the Fed has been on a historic, aggressive rate hike campaign in an effort to cool four-decade high inflation, which has in turn pummeled the stock market and created cracks in the unusually strong labor market.

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