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

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.