The Personal Consumption Expenditures Price Index (PCE), the Federal Reserve's preferred inflation metric over the past 25 years, came in lower than expected recently, encouraging news for Wall Street.
According to the Bureau of Economic Analysis, July's PCE inflation figure was up 2.6% year over year, in line with the median 2.6% increase expected by economists and well above the Fed's 2% target.
More recent data on inflation also painted a similar picture. Specifically, the July Consumer Price Index (CPI) arrived in line with estimates and suggested a moderate impact from President Donald Trump's tariff policies.
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Having these multiple reports on inflation may have some folks wondering what the difference is between PCE and the more commonly quoted CPI.
More importantly, there may be some market participants unsure as to why the Fed prefers the PCE over other inflation metrics, such as CPI, as it has done since 2000 when former Federal Reserve Chair Alan Greenspan made the PCE the Fed's preferred inflation gauge.
To understand why, let's dig into the details.
Why does the Fed use PCE instead of CPI?
CPI and PCE inflation tend to be pretty similar. However, there are a few noteworthy differences in what is included in the indexes, how things are weighted and how each index adjusts for real-world changes.
The Consumer Price Index measures out-of-pocket expenses for urban consumers on a fixed basket of goods and services. These include basics such as food, rent and gas.
The Personal Consumption Expenditures Price Index casts the net a little wider to include spending on behalf of American households by others. This means things such as employer-paid health insurance or Medicare and Medicaid benefits. As such, you could argue that the PCE gives a generally more complete picture of inflation.
This is one reason the Federal Reserve prefers the PCE over the CPI. It includes a wider assortment of items covering a larger percentage of the U.S. population.
While the CPI and PCE generally trend in the same direction, there can be some significant differences due to the weightings of items.
For example, housing accounts for a massive 33% of the CPI but only 15% of the PCE. Part of this is because the CPI focuses on urban consumers, whereas the PCE includes rural populations , whose housing tends to be cheaper.
This doesn't mean one is "right" or the other is "wrong." But to understand and interpret either, you need to know what's included in the numbers. The Fed has taken the view that the PCE's weightings are more reflective of the day-to-day reality of the typical American.
Most important perhaps is that there is a major difference in the way the two inflation metrics are calculated. The CPI uses a fixed basket of goods and services, which assumes that people buy the same things every month. It makes no allowance for behavior changes due to rising prices.
The PCE, meanwhile, uses a chained index. This accounts for how Americans substitute goods when prices change. For example, if chicken gets unusually expensive due to a bird flu outbreak, beef or pork might be comparatively cheaper.
This might encourage folks to shy away from chicken and opt for a lower-priced alternative instead.
Because the PCE reflects (or attempts to reflect) real-world spending changes, it tends to report lower and smoother inflation.
Does this mean the Fed is "cheating" by cherry-picking an inflation metric that is often lower?
Not at all.
The Fed wants to avoid getting distracted by the noise and focus on real trends.
Returning to the chicken example, the soaring price of chicken and eggs in the United States isn't due to inflation, per se. It's due to a nasty avian pandemic that is reducing the chicken population. It's a supply shock, not a demand-based surge brought on by excessively loose monetary policy.
But if food prices are rising in general, that's a different story. That would be a sign of real, systemic inflation. The PCE inflation gauge does a better job of communicating this real, systemic inflation to the Fed's policymakers.
The bottom line on PCE
Is the Fed "right" to use PCE inflation?
That's open to debate. But of the major inflation indexes tracked today, the PCE's broad product and geographic focus and its attempts to model real-world spending changes make it a worthy choice for the Fed.
Related content
-
How Digital Platforms Are Changing the Way You Invest in GoldInvesting in gold is easier than ever thanks to digital platforms. Learn how online tools are lowering costs, increasing transparency and making gold accessible to all investors.
-
Stocks Rise to Start Fed Week: Stock Market TodayThe Nasdaq Composite and S&P 500 hit new record closing highs as Wall Street awaits the Fed's next rate cut.
-
How Digital Platforms Are Changing the Way You Invest in Gold
Investing in gold is easier than ever thanks to digital platforms. Learn how online tools are lowering costs, increasing transparency and making gold accessible to all investors.
-
Stocks Rise to Start Fed Week: Stock Market Today
The Nasdaq Composite and S&P 500 hit new record closing highs as Wall Street awaits the Fed's next rate cut.
-
Don't Disinherit Your Grandchildren: The Hidden Risks of Retirement Account Beneficiary FormsStandard retirement account beneficiary forms may not be flexible enough to ensure your money passes to family members according to your wishes. Naming a trust as the contingent beneficiary can help avoid these issues. Here's how.
-
This Is How Life Insurance Can Fund Your Dreams NowBeyond a death benefit, life insurance can provide significant financial value and flexibility through 'living benefits' while you are still alive, helping with expenses like education, business ventures or retirement.
-
Potential Trouble for Retirees: A Wealth Adviser's Guide to the OBBB's Impact on RetirementWhile some provisions might help, others could push you into a higher tax bracket and raise your costs. Be strategic about Roth conversions, charitable donations, estate tax plans and health care expenditures.
-
One Small Step for Your Money, One Giant Leap for RetirementSaving enough for retirement can sound as daunting as walking on the moon. But what would your future look like if you took one small step toward it this year?
-
This Is What You Really Need to Know About Medicare, From a Financial ExpertHealth care costs are a significant retirement expense, and Medicare offers essential but complex coverage that requires careful planning. Here's how to navigate Medicare's various parts, enrollment periods and income-based costs.
-
I'm a Financial Planner: Could Partial Retirement Be the Right Move for You?Many Americans close to retirement are questioning whether they should take the full leap into retirement or continue to work part-time.
