Why Does the Fed Prefer PCE Over CPI?
Inflation has been top of mind for lots of folks in recent years. Most of Wall Street follows the CPI, but the Fed favors the PCE. Here’s why.
By Steven Orlowski, CFP, CNPR
Inflation has re-entered the economic spotlight over the past few years, impacting everything from grocery bills to interest rates. As investors, consumers, and policymakers try to make sense of rising prices, they turn to various inflation gauges. The two most widely referenced are the Consumer Price Index (CPI) and the Personal Consumption Expenditures Price Index (PCE).
Most of Wall Street keeps a close eye on CPI. It’s what the media reports monthly, and it tends to grab headlines with big, bold numbers. But when it comes to setting monetary policy, the Federal Reserve leans more heavily on the PCE. Why the preference? The answer lies in the differences in methodology, scope, and flexibility between the two indices.
CPI vs. PCE: A Quick Primer
CPI, compiled by the Bureau of Labor Statistics (BLS), measures the average change in prices urban consumers pay for a fixed basket of goods and services. This basket includes categories like food, housing, apparel, and medical care. It reflects out-of-pocket spending and doesn’t account for changes in consumer behavior.
PCE, published by the Bureau of Economic Analysis (BEA), takes a broader view. It tracks prices of goods and services consumed by households—whether paid directly or on behalf of consumers (such as employer-sponsored healthcare). It uses business surveys and adjusts for substitutions consumers might make when prices change.
1. Substitution Effects: PCE Adapts, CPI Doesn’t
One key reason the Fed favors PCE is its ability to account for substitution. If beef prices skyrocket, consumers might buy more chicken. CPI sticks with beef in its fixed basket, while PCE recognizes the shift. This makes PCE a more flexible, realistic measure of consumer behavior.
2. Weighting Differences: PCE Captures Broader Spending Patterns
CPI’s weightings are based on a household survey that tracks what urban consumers buy. PCE, on the other hand, uses a wider data set, including business surveys and national accounts. That means PCE captures spending by a broader swath of the population—including rural households, nonprofits, and healthcare paid by third parties. It paints a more comprehensive picture of consumption across the economy.
3. Healthcare Treatment: PCE Includes More
Healthcare is a major point of divergence. CPI only includes what consumers pay directly—co-pays, premiums, prescriptions. PCE includes expenditures paid on behalf of consumers, such as employer-provided insurance and government programs like Medicare and Medicaid. Since healthcare spending is a big part of GDP, this makes PCE a more complete measure.
4. Revisions and Timeliness: PCE Is Smoother
CPI is reported earlier and tends to be more volatile. PCE comes out later, but it’s more stable due to smoothing and revisions. The Fed values this stability when assessing trends over time and making interest rate decisions.
5. Historical Consistency and Policy Framework
In 2012, the Federal Reserve officially adopted a 2% inflation target—as measured by the PCE index. Since then, it has remained the Fed’s preferred inflation gauge because of its consistency with their policy goals and economic models.
Bottom Line
While CPI grabs headlines and influences market reactions, the Fed plays the long game with PCE. Its broader scope, built-in substitutions, and comprehensive healthcare accounting give it a better read on overall inflation and consumer behavior.
So, next time you hear about CPI ticking up or down, remember: it’s important—but it’s not the Fed’s north star. For the people setting interest rates, it’s the PCE that really matters.
Want to track the Fed’s favorite inflation measure? Watch for the monthly PCE release—usually a few weeks after the CPI. It may not get the same press, but it carries the weight where it counts.
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