How The Fed Measures Inflation, And What That Means For You

In their latest economic projections, central bankers predicted that inflation would cool to 2.4 percent by the end of the year. Over the final three months of 2023, core PCE registered 2% annualized growth for the second straight quarter, according to data released by the Bureau of Economic horarios de forex Analysis on Thursday. PCE also reports that, during the month of April, personal income increased by 0.4 percent, or $89.3 billion. Disposable personal income (DPI) increased 0.3 percent, or $48.3 billion. Personal consumer expenditures for the month increased 0.9 percent, or $152.3 billion.

  1. After declining by 0.1% in November—the first outright decline since the onset of the Covid-19 pandemic in April 2020–economists predict headline PCE ticked up on a monthly basis by 0.2% in December.
  2. Fed Chair Jerome Powell has said officials are most concerned about stubborn inflation for such services.
  3. The Commerce Department’s personal consumption expenditures price index for December, an important gauge for the Federal Reserve, increased 0.2% on the month and was up 2.9% on a yearly basis, excluding food and energy.
  4. In other economic news, the Chicago manufacturing reading came in at a higher than expected 75.2, its highest level since November 1973.

The PCE index reported a 6.3 percent inflation rate over the 12-month period ending in April. March, February, and January saw a bump of 6.6, 6.3, and 6.0 percent, respectively. This means inflation is cooling for the first time in the current spree, according to the BEA. The Fed’s main (and arguably, only) weapon in its arsenal to fight inflation is to raise interest rates.

PCE vs. CPI: What’s the difference?

Headline inflation was flat on the month and at a 3% rate for the 12-month period, the release also showed. Energy prices fell 2.6% on the month, helping keep overall inflation in check, even as food prices increased 0.2%. For example, if the price of bananas went to $20 each, it’s quite likely that most consumers would buy a lot fewer bananas and switch to buying more apples or other fruits. PCE data would, theoretically, pick up on this during the month it occurred as business sales for bananas would fall. However, the CPI index would only pick up a change with its next weighting update which could be 1 or 2 years away.

Personal consumption expenditures, or PCE, allows economists, consumers, and businesses to see how well the economy is faring from month to month. The PCE data for December 2023 showed an increase in personal consumption expenditures to just over $19 trillion, which is an increase of 0.7%. Disposable personal income remained fairly flat from the previous month at $16.95 trillion. Some observers feel that this reflects the inability to value personal consumption expenditures accurately. According to the BEA, most PCE (valued by market prices, including sales tax) comes from household purchases of new goods and services from private businesses.

In the United States, employer health insurance is a large component and accounts for much of the difference in weights. Then we have the two most common measures of the prices that consumers are paying. From a financial market standpoint, CPI inflation is released earlier in the month for the prior month, so often gets a little more attention.

Fed Preference for the PCE Price Index

This is one reason CPI inflation can come in slightly higher than CPE inflation on average. However, though there is an impact here, research suggests that the relationship is weaker than you might expect. The data came as a rising number of Omicron infections makes the inflation and economic outlook hazier.

The CPI and PCE each come in two flavors, a so-called “headline” measure and a core measure, which strips out the more volatile food and energy components. Like the headline measures, core CPI tends to show higher inflation than core PCE. Since 2000, core CPI has averaged annual increases of 3.9 percent, and core PCE has averaged 3.4 percent, the same half a percentage point difference as between the headline numbers.

The two most frequently cited indexes that calculate the inflation rate in the U.S. are the Consumer Price Index (CPI) and the Personal Consumption Expenditures Price Index (PCE). These two measures take different approaches to measuring and calculating inflation. Another way to think about inflation is in the context of the value of a country’s currency, like the U.S. dollar. As the purchasing power of each dollar declines, the general cost of living goes up. Because now the public spends the same amount of money but gets fewer things for it. For the same month, the CPI is up 0.3 percent, suggesting slight divergence from the 0.2 percent reported in the PCE index.

When could inflation come down?

In theory, this curbs consumer spending, makes borrowing more expensive and puts pressure on businesses, leading to higher unemployment rates. In short, the headline PCE data is good news, but core inflation suggests stickiness. Are the results enough to persuade economists and the Fed that enough work is being done to tackle inflation? There have been some indications recently that the Fed is at least willing to start talking about reducing the pace of asset purchases, but any real action is likely months away. Central bankers see the ongoing price pressures as temporary, due to supply chain bottlenecks and comparisons to last year when the economy was largely shut down.

If it feels like we’ve been discussing a recession forever, it’s because we have. While inflation remains sticky, raising interest rates to fight it is a double-edged sword. Too much stress on the system can lead to failures, as we saw in March with the regional banks. The PCE price index is the Fed’s preferred gauge of inflation, and on the face of it, the data looked good. Headline PCE inflation rose 3.8% from a year earlier, which is the lowest figure in two years.

But after stripping out food and fuel costs, which can move around from month to month, a “core” price index climbed 2.9 percent from December 2022. That followed a 3.2 percent November reading, and was the coolest since March 2021. Inflation has been slowing swiftly, and fresh data showed that a core price gauge fell below 3 percent for the first time in years last month. Say the price of gasoline rises in a given month but the price of tomatoes falls. Gasoline represents a larger portion of a family’s monthly budget, so it’s weighted more heavily in calculating PCE.

One reason for this is that businesses add on a margin to make a profit, and those margins change over time and impact the prices consumers pay. Though margin changes don’t appear in the PPI data and can make a big difference to consumers. This means inflation data tells us if prices are rising or falling and how fast. You can probably see that inflation is also a series that has a strong trend component to it. For example, coming back to the weight example, if you gain five pounds in January then unless something changes then you’ll unfortunately still have those five pounds for the rest of the calendar year. Many economists credit the Fed’s sharp rate hikes — which boosted its benchmark rate from near zero to about 5.4% after the most recent hike in July — with cooling demand and helping slow inflation.

The CPI formula is more likely to be affected by categories with wide price swings such as computers and gasoline. The PCE calculations smooth out these price swings, which makes the PCE less volatile than the CPI. The PCE price index collects data on some different types of goods and services than the CPI does. The Bureau of Economic Analysis (BEA) estimates the PCE price index each month and publishes its findings in a report called “Personal Income and Outlays.” The Cleveland Fed is part of the Federal Reserve, the central bank of the United States.

A measure of consumer confidence by the University of Michigan, for example, has jumped in the past two months by the most since 1991. The Fed compares the core PCE inflation rate to the Fed’s 2% target inflation rate. If it is below 2%, the Fed will lower interest rates and use its other tools to spur consumer demand. If the core rate is above 2% for an extended period, then the Fed will take action to prevent inflation. The BEA reports the total value of personal consumption expenditures collectively every month.

A report Friday is expected to show that U.S. employers added 168,000 jobs in July, a significant slowdown from earlier this year, but the unemployment stayed near a half-century low at 3.5%. The Fed’s inflation report comes the same day as encouraging news from the euro zone. But the Consumer Price Index – or CPI – assumes Thomas is cranking the heat as much as she did a year ago, and, that other consumers are buying like they used to. The PCE price index and the CPI use different types of formulas to calculate price changes.

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