The Federal Reserve (Fed) considers all measures of inflation when setting monetary policy; however, Personal Consumption Expenditures (PCE) became its primary inflation gauge in early 2000. Prior to 2000, the Fed focused on the Consumer Price Index (CPI). As St. Louis Fed President James Bullard notes, the switch to PCE was made for three primary reasons: PCE includes a broader range of goods and services without the heavy shelter cost weighting in CPI, flexible expenditure weights in PCE eliminate the substitution bias in CPI (i.e. consumers choose less expensive options when available) and historical PCE data can be revised.
In this week’s chart, I measured the difference between the two most widely followed inflation gauges since the transition. Not surprisingly, PCE has registered consistently lower inflation readings with an average annual difference of nearly 50 basis points. The two inflation measures bracket the 2% target rate, but overall inflation in the United States has been stable throughout the period under either lens and within the Fed’s comfort zone.
Differences between the two inflation gauges, however, have significant impacts for the measurement of certain benefits tied to CPI such as Social Security payments and public pension funds with cost-of-living adjustments. Higher CPI readings also benefit returns for Treasury Inflation Protected securities (TIPs), whose principal balance adjusts to CPI. TIPs are also used to measure the market’s expectation for future inflation (so-called breakeven inflation), a critical element for Fed monetary policy decision-making.
The persistent differential between PCE - the Fed’s favorite inflation gauge - and CPI - the source of market expectations for future inflation - raises numerous questions for investors. Should the Fed have a higher target than 2% for breakeven inflation to reflect the systematic bias in CPI? As St. Louis Fed President Bullard suggests, should the federal government choose a standard measure of inflation to provide more clarity on consumer inflation? Will a switch to PCE alleviate pressures on mounting federal government deficits and underfunded public pension plans? I expect the transition to a standard inflation measure will prove too challenging anytime soon for our highly polarized federal government, but understanding the methodical differences between the two inflation gauges will help inform better decision-making for investors.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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