The BEA's core Personal Consumption Expenditures (PCE) Price Index for August showed that core inflation continues to be above the Federal Reserve's 2% long-term target at 2.7%. The August core Consumer Price Index (CPI) release was higher, at 3.2%. For a closer look at each of those releases, check out our latest Consumer Price Index and PCE Price Index releases.
Preferred Inflation Gauge
The Fed is on record as using core PCE data as its primary inflation gauge.
The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances. [Source] Note: bolding added.
Elsewhere, the Fed stressed the importance of longer-term inflation patterns, the likelihood of persistence and the importance of "core" inflation (less food and energy). Why the emphasis on core inflation? Here is an excerpt from one of the Fed FAQs.
Finally, policymakers examine a variety of "core" inflation measures to help identify inflation trends. The most common type of core inflation measures excludes items that tend to go up and down in price dramatically or often, like food and energy items. For those items, a large price change in one period does not necessarily tend to be followed by another large change in the same direction in the following period. Although food and energy make up an important part of the budget for most households — and policymakers ultimately seek to stabilize overall consumer prices — core inflation measures that leave out items with volatile prices can be useful in assessing inflation trends. [Source]
PCE and CPI: A side-by-side comparison
This close-up comparison gives us clues as to why the Federal Reserve prefers core PCE over core CPI as an indicator of its success in managing inflation: Core PCE is considerably less volatile than CPI. Given the Fed's twin mandates of price stability and maximizing employment, it's not surprising that, in the past, the less volatile core PCE has been its metric of choice. On the other hand, the disinflationary trend in core PCE (prior to 2022) casts doubt on the effectiveness of the Fed's monetary policy.
The Bureau of Labor Statistic's Consumer Price Index and the Bureau of Economic Analysis's monthly Personal Income and Outlays report are the main indicators for price trends in the U.S. Here is a long-term perspective from the actual beginnings of the two series. It’s easy to see that both series track each other closely and tend to move in the same direction. However, again we can see that core CPI is the more volatile of the two.
The next chart narrows our timeframe by looking at core CPI and core PCE since the turn of the century. As you can see, during this timeframe, inflation never moved above 3% before 2021. But over the last two and a half years, because of the COVID pandemic, we have seen some of the highest inflation rates since the early 80s. In April 2021, both core indexes jumped to their highest levels in over 25 years and for the next year, we watched inflation climb higher and higher. Then, in February 2022, core PCE peaked at 5.57% while core CPI peaked later that year in September at 6.63%. Since then, we’ve seen both series slowly progressing back towards the Fed’s 2% target rate, with core CPI currently at 3.2% and core PCE currently at 2.7%.
In the previous two charts, it was easy to see that inflation measured by core CPI tends to be higher than core PCE. In fact, since 1960, it has registered a higher reading 79% of the time. But just how much higher?
This next chart helps answer that question by showing the spread between the two core metrics since 1960. On average, core CPI has been 49 basis points, or 0.49%, higher than core PCE. As of August, the latest spread between the two is 52 basis points, or 0.52%.
Here is a chart that helps us compare the cumulative change in the two indexes since 1960. At first glance it may seem like the two have grown at relatively similar rates. However, note that CPI is reflected on the left axis, where the maximum growth rate is 1,000%, while PCE is reflected on the right axis, with a maximum growth rate of 800%. With that in mind, over time, the PCE price index indicates significantly lower growth in inflation than does CPI. As of August, core CPI has grown 974% since 1960 while core PCE has only grown almost 1/3 less at 677%.
For some technical data explaining the differences between the calculation of PCE and CPI, see this comparison article from the BEA.
We can't exclude food and energy from our monthly expenses. But the extreme volatility of these two expense categories, especially energy, often obscures the underlying trend, which is the focus of the chart above. For evidence of the volatility, see this overlay of headline and core CPI and this one of headline and core PCE.
Hostility Toward Government Inflation Analysis
On the other hand, the volatile price of gasoline explains why so many people are confused by the exclusion of food and energy from core measures of inflation. The chart of gasoline prices below is based on the latest weekly data from the Energy Information Administration.
During inflationary times, investors sometimes turn to agricultural commodity ETFs such as Teucrium Wheat Fund (WEAT) and Teucrium Corn Fund (CORN).
