Month: January 2023

The Increasing Popularity of the PCE Inflation Gauge

US inflation, by a number of official measures, reached its highest level in 40 years last year. For a large percentage of investors and shoppers, this is their first experience of prices quickly rising. For decades, on many tech products, prices declined over time (while adding functionality). There are a number of different measures of inflation reported regularly – they impact us in different ways. Knowing the difference, whether you’re investing, planning a purchase, or expecting a cost of living (COLA) increase, is helpful. Below we go through the different measures so you understand the impact of say “headline CPI” versus “core PCE.”

According to James Bullard, the president and CEO of the Federal Reserve Bank of St. Louis,  “measuring inflation is one of the most difficult issues studied by economists.”

By definition, inflation is the percentage change in overall prices in the economy over a specified period, commonly quoted as a year-over-year change. It’s much more than an increase in the prices of a few products. Given the inherent difficulties in following every price in the country, economists have created price indexes to approximate the overall price level.

PCE Inflation

Before the year 2000, the Federal Open Market Committee (FOMC) primarily focused on the Consumer Price Index (CPI) as its inflation gauge. We’ll explain CPI next, but for the Fed, when it now says it has a 2% inflation target, PCE is the data used.

Though the two indexes have a lot of overlap, there are reasons why the PCE is considered a better tool by policymakers.

The PCE price index, which rose 5.5% in November 2022 from a year earlier, is derived from a broader index of prices than the CPI’s more narrow set of goods and services. The argument as to why policymakers gave an edge in the late 1990s to make the change in 2000 is that a more comprehensive index (such as PCE) of prices provides a better way to gauge underlying inflationary pressures. Since the PCE includes more goods and services, the index’s weights for particular items will differ dramatically from those in the CPI. For example, housing has a weight of about 16% in the PCE price index versus 33% in the CPI. The varied items more accurately reflect actual costs to consumers since they may substitute one for another as prices of items change at different rates. This ability to substitute is a primary reason why PCE tends to print lower than headline CPI.

CPI Remains Important

The most widely cited measure of inflation is the headline Consumer Price Index (CPI), which is calculated by the Bureau of Labor Statistics (BLS). This index was created in 1919 as officials devised a way to measure rising consumer prices just after World War I.

The CPI, which rose 6.5% for all of 2022, measures the price changes for a basket of goods and services purchased by the typical urban consumer. The items in this basket are weighted by their relative importance in consumer expenditures. For example, housing—rent and other spending on shelter—accounts for 33% of the index, while medical care accounts for nearly 9%.

This index, like others, takes into account changing consumption. New items come in and old items leave. The example I like to use is that prohibition began in January 1920, just after CPI came into use. Alcohol was not part of the index back then, whereas it is today (5.78% increase in 2022), product adoption changes.

The CPI weights had been adjusted every two years using two years of consumer spending data. Starting in 2023, the BLS will update weights annually using one year of data.

Headline PCE Inflation versus Headline CPI Inflation

The increasing popularity of the PCE is because the index’s weights are updated monthly, versus annually for CPI (prior to 2023 updates were every two years). Thus, the PCE can quickly reflect the impact of new technology or an abrupt change in consumer spending patterns. For example, the onset of the coronavirus pandemic quickly shifted consumption from services like restaurants to services like communication technology. Since the headline PCE uses more timely, actual outlays, it provides the FOMC a more accurate consumer experience in terms of inflation.  

The stated target by the FOMC is 2%, a level that policymakers judge to be consistent with achieving price stability and maximum employment. On average, inflation was hovering below this target before the pandemic’s economic ramifications (from 1995 through 2019 PCE average equaled 1.8%).  

Other Inflation Measures

While the FOMC targets headline PCE inflation, policymakers also watch other measures to gauge inflationary pressures. The headline PCE measure can be quite volatile due to the effects of extreme price movements for certain products. To get a sense of where underlying inflation really is, economists often look at some summary measure of inflation that doesn’t include these volatile prices.

A so-called “core” index—whether it be PCE or CPI—excludes food and energy components. That has some simplicity around it, but it’s not satisfactory. There are better ways to analyze underlying inflation than to throw out certain goods and services, especially those that hit low- to moderate-income consumers the hardest when prices rise. And even if you exclude food and energy prices, the remaining part of the index is still affected by their volatility; restaurant prices would be a classic example.

More recently, other statistical ideas have been developed. One method looks at price change distribution for the entire range of goods and services.³

One commonly used measure of this type is the Dallas Fed trimmed-mean PCE inflation rate, which removes the upper tail (the largest price changes) and the lower tail (the smallest price changes) and then takes a weighted average of the price changes for the remaining components. This measure has been popular as a tool for examining trends and overall inflation as opposed to special factors that might be driving inflation. Of course, these types of measures⁴ tend to be more persistent and move more slowly than headline inflation measures.

Take Away

While market concerns over inflation for many years were low and most may have been more concerned about deflation, the current tight supply of goods and labor, coupled with the easiness of money, has ushered in a period where markets are likely to feel the impact of each inflation post.

Understanding the most watched inflation gauges will help sort out whether a trend or single post is likely to cause a change in course on interest rates. Or is it more likely a blip that will on average work its way out? The Fed is currently targeting a PCE inflation rate of 2%. The current pace is more than double this, but trending down after the Fed tightened in 2022 at a record pace. The Fed and the markets are now awaiting the impact of those cuts as there is a lag in applying the economic brakes (to lessen inflation) and when the economy has its biggest reaction to the Fed’s heavy pressure on the brake pedal.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm

https://files.stlouisfed.org/files/htdocs/publications/review/11/07/bullard.pdf

https://www.usinflationcalculator.com/

https://ycharts.com/indicators/us_consumer_price_index_alcoholic_beverages_unadjusted

https://www.stlouisfed.org/publications/regional-economist/2022/sep/making-sense-inflation-measures#authorbox