CPI vs. Core PCE Price Index: What's the Difference and Which Does the Fed Pay More Attention to?

When assessing the direction of US inflation, market participants often rely on two important indicators: the Consumer Price Index (CPI) and the Core Personal Consumption Expenditures Price Index (Core PCE). Both measure changes in prices paid by consumers, but they have different scopes, calculation methods, and functions. Therefore, the CPI and Core PCE do not always move at the same rate, even though they both reflect inflationary pressures.

What is the CPI?

The Consumer Price Index (CPI) measures price changes in a basket of goods and services commonly consumed by households. Its components include food, energy, housing, transportation, healthcare, clothing, and various other services.

The CPI is typically one of the inflation indicators that garners the market's most immediate attention because it provides a direct glimpse into changes in consumers' cost of living. When the CPI rises higher than expected, the market can assess that inflationary pressures remain strong. Conversely, a slowing CPI can signal an ongoing process of declining inflation, or disinflation.

However, the CPI is quite sensitive to changes in the prices of volatile components such as energy and food. A sharp increase in oil prices, for example, can quickly push the CPI up even if price pressures in other sectors are relatively contained.

What is the Core PCE Price Index?

The Core Personal Consumption Expenditures Price Index, or Core PCE, also measures changes in the prices of goods and services consumed by the public. The difference is that this indicator excludes food and energy components because the prices of these two groups tend to fluctuate significantly.

By omitting food and energy, the Core PCE is considered to provide a clearer picture of underlying inflationary pressures in the economy.

The Core PCE also covers a broader range of consumption items. This indicator can include expenditures made by consumers but not necessarily paid directly by those consumers. Examples include some healthcare expenditures paid by companies, government programs, or third parties.

This is one reason why the Core PCE's movements can differ from the CPI's.

Key Differences Between CPI and Core PCE

Simply put, the differences can be seen in several aspects. First, price coverage: The CPI focuses on goods and services purchased directly by consumers, while the PCE covers a broader range of consumption.

Second, food and energy: The headline CPI still includes food and energy. Core PCE, on the other hand, specifically excludes these two components to make underlying inflation trends more easily visible.

Third, expenditure weights: The CPI uses weights based on regularly updated consumer spending patterns. The PCE uses a more flexible method, allowing it to capture changes in consumer behavior when people substitute expensive goods for cheaper alternatives.

For example, when beef prices rise sharply and people start buying more chicken, this change in consumption patterns can be more quickly reflected in the PCE calculation.

Fourth, data source: The CPI is published by the Bureau of Labor Statistics (BLS), while the PCE Price Index is part of the income and expenditure data published by the Bureau of Economic Analysis (BEA).

Why Does the Fed Pay More Attention to the PCE?

While the CPI receives significant investor attention, the Federal Reserve uses the PCE Price Index as its primary measure for assessing its inflation target.

The Fed's long-term inflation target of around 2% is based on the PCE, not the CPI. Meanwhile, Core PCE is often used by market participants to assess whether underlying inflationary pressures remain strong or are easing.

This is because the PCE has a broader scope and a more flexible consumption weighting. This makes it considered more capable of reflecting real changes in consumer spending behavior.

However, this doesn't mean the CPI is unimportant. The CPI remains closely watched because it is usually released earlier and can provide early clues about the direction of inflation before the PCE data is released.

How Does It Impact the Market?

If the CPI is higher than expected, the market typically begins to consider the possibility of the Fed maintaining high interest rates for longer. US bond yields and the dollar can gain support, while gold could potentially come under pressure.

Conversely, a lower-than-expected CPI could raise expectations for looser monetary policy. Such conditions generally tend to put downward pressure on the dollar and bond yields, thereby creating room for gold to strengthen.

However, Core PCE may serve as a more crucial confirmation of the Fed's policy direction. If the CPI falls but Core PCE remains high, the central bank may not yet be fully convinced that inflation is truly under control.

On the other hand, if the CPI, Core CPI, and Core PCE consistently show a slowdown, confidence that inflationary pressures are easing could strengthen. This scenario could increase the likelihood of looser interest rate policies.

Conclusion

While both CPI and Core PCE measure inflation, they view price pressures from different perspectives.

The CPI better reflects changes in the cost of living directly experienced by consumers, making it highly sensitive to food, energy, and housing prices.

Meanwhile, Core PCE is primarily used to gauge underlying inflation trends and serves as a key indicator in the Fed's policy deliberations.

Simply put:

CPI = how prices experienced by consumers change.

Core PCE = how underlying inflationary pressures evolve after excluding the volatile effects of food and energy.

For traders, the CPI can act as an early signal that moves markets quickly, whereas Core PCE often serves as a vital confirmation for gauging the direction of the Fed's interest rate policy. (mrv)*

Source: Newsmaker.id