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- Comparing apples and oranges
“Are we there yet?” Back in December, at the peak of optimism that inflation would prove transitory after all, investors priced in six or seven rate cuts by the U.S. Federal Reserve (Fed) for 2024. Like kids in the back seat of the family car going from sugar highs to sulky lows, they have since slashed those bets, with many wondering whether the Fed will ever get there.
Our Chart of the Week attempts to give some grown-up context to these debates. It shows two measures of core inflation, which exclude volatile energy and food prices. Concerns about inflation persistence largely stem from readings of the consumer price index (CPI) in recent months. As the first inflation data points published each month, CPI and core-CPI naturally tend to capture the market imagination. Headline CPI also used to be the Fed’s preferred inflation gauge until the late 1990s, though already back then, it tended to focus on core readings in the short run to get a better idea of underlying inflation dynamics.[1]
Nowadays, most economists and central bankers, including those at the Fed, prefer to target personal consumption expenditures (PCE). Our chart shows the most recent core readings for both PCE and CPI, excluding volatile energy and food prices. Because the two measures are constructed differently, they often diverge. For the CPI, weights of goods and services are adjusted only relatively rarely; following the most recent changes, weights are now based using a single calendar year of data on consumption patterns, which yields a lag of 24 months.[2]
Sticky or not that Sticky? A tale of two divergent inflation measures
Sources: U.S. Bureau of Labor Statistics, U.S. Bureau of Economic Analysis, Haver Analytics, DWS Investment GmbH as of 4/29/24
By contrast, weights for the PCE measure tend to reflect substitution effects relatively quickly, as they are based on what consumers actually buy.[3] When relative prices change, consumers naturally tend to shift from more expensive goods and stores to cheaper ones. Think of how sensitive your fruit purchases are, if, say, a bad harvest drives up the relative price of oranges compared to all other fruits.
Other differences between the two measures include the fact that CPI is survey based, relying mostly on what consumers in urban areas say they have spent money on. By contrast, the PCE index uses actual spending. It includes rural consumers and more accurately captures costs such as health care, for which many consumers do not pay themselves and may not even know the total cost.
All this can result in big divergences. For example, airfares pushed up the CPI reading for February, based on prices for a fixed set of flight routes, while PCE readings were much lower.[4] Rents have an outsized impact on the CPI, they are used to determine the cost of owner-occupied houses, as well as properties actually rented. Costs of shelter account for roughly 30% of the CPI basket but have only a weight of about 15% in the PCE. Prices for shelter proved to be a constant nuisance for economists after the pandemic. Usually, the shelter component in CPI (or housing in PCE) follows the various available house-price and rent indices with a quite robust time lag of 12 months. But when it comes to the economic impact, it is worth keeping in mind that a lot of what the measures concerns housing costs in urban areas that are simply imputed, rather than what consumers – including rural ones - actually spend on housing.
None of which is a reason for the Fed to prematurely declare victory. CPI is widely watched, and hence important in anchoring inflation expectations. Moreover, plenty of questions remain as to what caused inflation to get out of hand in the first place, as the Financial Times Martin Wolf recently pointed out in a remarkable column.[5] “The reality is that forecasting failures by markets and central banks alike are quite common, because no one really knows what the future will hold, let alone how complex systems, such as whole economies, might react to a shock in the real world,” explains Christian Scherrmann, U.S. economist at DWS. “The best we can hope for is that by paying careful attention to all incoming data, we avoid such sharp swings in assessments as markets have experienced in recent months. The Fed is right to be patient.”
