Inflation measures are crucial for understanding the economic landscape, but different indicators can paint contrasting pictures. While the Consumer Price Index (CPI) often grabs headlines, the Federal Reserve primarily focuses on the Personal Consumption Expenditures (PCE) price index to gauge inflation.
In January, the Commerce Department’s report showed a 0.3% increase in overall consumer prices, with a year-over-year rise of 2.4%. However, the CPI for the same period showed a higher year-over-year increase of 3.1%. Similarly, core PCE, which excludes food and energy items, rose 2.8% year-over-year, while core CPI increased by 3.9%.
This disparity between CPI and PCE prices is not uncommon, but the recent gap has been notably wide. Historically, the median difference between the two indices over the past six decades has been just 0.4 percentage points. The variance arises from differences in composition; CPI weights are based on consumer surveys, while PCE weights reflect actual spending patterns derived from Commerce Department data.
For instance, the data reveal that Americans allocate a significantly larger portion of their spending to alcohol according to Commerce Department figures compared to consumer surveys used in the CPI calculation.
The Federal Reserve shifted its focus to the PCE index in the late 1990s, favoring it over the CPI due to perceived accuracy in spending data. Former Fed Chairman Alan Greenspan notably expressed preference for the PCE during a policy meeting in December 1999, criticizing the CPI in the process.
Alan Greenspan’s skepticism about the accuracy of the Consumer Price Index (CPI) compared to the Personal Consumption Expenditures (PCE) index led the Federal Reserve to formally adopt the PCE as its preferred price measure in 2000. Even when the Fed established a 2% inflation target in 2012, it was based on PCE inflation.
One significant difference between the CPI and PCE indices is the weighting of housing costs. Shelter expenses make up a larger portion of the CPI (about 34%) compared to the PCE (about 15%). As housing costs, particularly rents, have been rising, they have contributed significantly to the CPI’s inflation rate. However, since shelter costs have a lower weight in the PCE, their impact on PCE inflation is less pronounced.
While most economists anticipate a moderation in shelter costs over the coming year, this may affect CPI inflation more than PCE inflation due to the CPI’s higher housing weight. On the other hand, the PCE’s lower housing weight means that other categories, such as healthcare services, have a greater influence. Healthcare services constitute a larger share of the PCE (16.1%) compared to the CPI (6.5%), which could lead to divergent inflation trends between the two indices.
Healthcare services inflation in the CPI has been outpacing that in the PCE recently, and this trend is expected to persist. Consequently, the gap between CPI and PCE inflation is likely to remain wide throughout the year. Despite potential volatility in core CPI and core PCE in the coming months, both measures are expected to moderate, with core CPI projected to increase by 2.6% year-over-year by December and core PCE by 2%. This cooling trend in inflation could make the Fed more inclined to consider rate cuts.