Investors are facing confusion over which inflation report to track – the widely quoted Consumer Price Index (CPI) or the Federal Reserve’s preferred Personal Consumption Expenditures (PCE) data.
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One of these inflation measures currently suggests the U.S. is winning its fight against inflation, while the other tells a conflicting story. The confusion has investors understandably asking the question, how can the same economy spit out two very different inflationary tales?
First, it’s important to recognize the clear differences in the methodologies used to calculate CPI and PCE, indicating the extent of price increases for Americans. While both indices usually align closely, differing by rarely more than 0.3%, their methodologies can at times yield significantly different results. Investors should also understand the reason behind the Federal Reserve’s preference for one over the other. With this understanding, investing amid this mix of inflation data becomes less of a mystery.
How the CPI and PCE Reports are Different
The Consumer Price Index (CPI) measures prices of the same fixed basket of goods month-to-month and year-to-year and then compiles the difference in the total price of the same basket of items.
Alternatively, Personal Consumption Expenditures (PCE) measure the costs of what was actually purchased within the U.S. month-to-month and year-to-year. Therefore, if consumers decided to buy less of a more expensive luxury item, like substitute cheaper candy for more expensive chocolate, the inflation report would express what was actually experienced by consumers.
Additionally, CPI includes only out-of-pocket expenses for consumers, whereas PCE measures the full cost. This comes into play when medical costs rise rapidly, CPI may measure the same out-of-pocket cost for consumers as in previous periods, while PCE would reflect a big increase as the procedure did cost more, even if insured consumers weren’t billed a higher amount.
Disparity in CPI and PCE Inflation Reports
In the latest readings of the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) inflation measures, a significant disparity became evident, amounting to a full percentage point difference.
Interestingly, the PCE price index from last week demonstrated core annual inflation at 2.8%. Here, ‘core’ signifies the exclusion of volatile food and energy costs from the calculation.
Contrastingly, an earlier release in March revealed that the ‘core’ CPI reflected a 3.8% increase in prices annually. Given the Federal Reserve’s objective of maintaining inflation at 2%, the PCE figure of 2.8% signals encouraging progress towards this target.
Conversely, the CPI figure of 3.8% surpasses the Fed’s target by almost double, potentially unsettling the market with concerns surrounding higher inflation levels.
Primary Cause of Discrepancy in Readings
One category alone, housing, can explain the large difference in readings. Notably, housing or shelter accounted for a 1.5% addition to costs in CPI over PCE. This difference primarily stems from how shelter expenses are weighted in each measure.
Housing holds approximately 43% of the total basket in core CPI, while it represents 17.5% of the core PCE. Year-over-year, housing costs in CPI rose by 5.9%, a figure similar to the 5.8% increase in PCE. However, the substantial impact on the final numbers arises from the contrasting weights of 43% in CPI compared to 17.5% in PCE.
The Disparity Could Impact the Fed
The Federal Reserve’s 2% inflation target, tied to PCE inflation, may encounter confusion due to the disparity between CPI and high housing inflation.
After reviewing the February PCE report, Fed Chair Powell remarked that the data was not as low as the favorable readings from the second half of last year, but it aligns more closely with their desired outcomes. This puzzling statement suggests that while the Fed finds the data reassuring, it refrains from declaring victory in its battle against inflation.
Key Takeaway
In summary, investors face a dilemma in choosing between the often cited Consumer Price Index (CPI) report and the Federal Reserve’s preferred Personal Consumption Expenditures (PCE) data, as they present contrasting views on the state of inflation in the U.S. The distinct methodologies used in calculating CPI and PCE highlight notable discrepancies in measuring price increases for Americans, leading to divergent results. Understanding these differences and the Fed’s preference for PCE can provide clarity for investors navigating the complex landscape of inflation data.
