By one measure inflation is closing in on the Federal Reserve’s 2% target. By another it is still far away. Whether, and how, that gap closes could be critical to Fed plans this year.
The Labor Department’s monthly report on consumer prices, known as the consumer-price index or CPI, is generally thought of as “the” inflation report. It generates headlines, features in politicians’ speeches and moves markets—including earlier this month when a hotter-than-expected report sent the Dow Jones Industrial Average tumbling over 500 points.
But the Labor Department’s figures aren’t the Fed’s focus. Instead, the central bank bases its 2% inflation target on the inflation data that comes out with the Commerce Department’s monthly report on income and spending. That is known as the personal-consumption expenditures price index, or PCE.
What the January numbers say
PCE prices run cooler than the CPI, and lately the gap between the two has been especially large. Thursday, the Commerce Department reported that overall consumer prices rose 0.3% in January from December, putting them up 2.4% from a year earlier. In contrast, the January CPI was up 3.1% from a year earlier.
PCE prices excluding food and energy items—the “core” figure that policymakers and economists watch in an effort to better understand inflation’s underlying trend—rose 2.8% in January from a year earlier. That compares with a 3.9% increase in core CPI. While core PCE almost always runs cooler than the core CPI, the difference between the two has rarely been so wide. In the 60 years before the pandemic, their median gap was just 0.4 percentage point.
What people spend, and what they say they spend
The biggest difference between the CPI and the PCE price indexes is their composition. The price weights for different items in the CPI depend on how much of their spending consumers say they devote to different items, based on annual surveys. The price weights in the PCE are based on what Commerce Department data suggest where money actually gets spent.
The gaps can be big. For example, the Commerce Department data show that Americans devote about twice as big a share of their spending to alcohol as the Labor Department figures.
A late 1990s shift in the Fed’s focus toward the PCE index was driven by a view that the spending data was more accurate than the survey data. The transcript from the Fed’s December 1999 policy meeting shows then-Chairman Alan Greenspan stating his preference for the PCE—and railing against the CPI.
“Why we should look at data based on a distorted sample when we have a universe whose data are more accurate is beyond me,” Greenspan said. In the Fed’s semiannual policy report to Congress in February 2000, the central bank formally made the PCE index its preferred price measure. In 2012, when it adopted a 2% inflation target, it was for PCE inflation.
Housing matters, and sometimes it matters more
One place where price-weight differences have mattered a lot lately is housing. In the CPI, shelter costs for homeowners and renters account for about 34% of the index’s weight. They account for only about 15% of the PCE.
Rising shelter costs contributed about two percentage points to the CPI’s 3.1% increase in January. In contrast, those costs added less than one percentage point to PCE inflation.
Most economists expect the shelter components for both the CPI and the PCE index to cool over the next year. For both renters and homeowners, shelter prices are derived from rents. These lag behind what is happening on newly signed leases, which are now rising much more slowly.
But because shelter costs count for so much more of the CPI’s weight than the PCE’s, if they moderate, they will cool CPI inflation more than PCE inflation.
What could happen next
Moreover, the flip side of the PCE’s lower housing weight is that other items have higher weights. If inflation in some of those proves stickier, it could exert more upward pressure on the PCE. Healthcare services are a concern here: They count for only 6.5% of the CPI, but 16.1% of the PCE. That is partly because the PCE includes prices for purchases made on behalf of consumers, such as medical care paid through Medicare.
The twist here is that while the Commerce Department uses CPI prices for many of the items in the PCE, for healthcare services it uses mostly different sources, points out Omair Sharif of Inflation Insights. As a result, healthcare services inflation in the CPI has been running warmer than in the PCE over the past several months—a trend he expects will continue. The upshot is that the gap between the CPI and PCE inflation “will remain relatively wide for most of the year.”
He also thinks that while core CPI and core PCE could be bumpy until the spring, both measures will ultimately cool, with core CPI up 2.6% from a year earlier by December, and core PCE up 2%. That could make the Fed much more comfortable about cutting rates.