Macro Monday 25~The Feds Inflation Barometer – Core PCE Macro Monday 25
The Feds Favorite Inflation Barometer – Core PCE
The US Core Personal Consumption Expenditures (PCE) are released this Friday 22nd December 2023. Currently Core PCE is the most important component to the Federal Reserve in making their interest rate decisions and thus it will provide a great insight into what lies ahead in terms of interest rate policy for Q1 2024.
Known as the Federal Reserve’s favorite gauge for inflation, Core PCE is a crucial economic indicator that provides insights into the general trend in consumer spending (it excludes the more volatile energy & food costs).
Jerome Powell
“I will focus on core PCE inflation, which omits the food and energy components.”
25th Aug 2023
The Bureau of Economic Analysis (BEA) compiles and publishes the Core PCE report which is considered a more comprehensive measure of general trends in consumer spending than some other indicators, such as the Consumer Price Index (CPI).
We will briefly cover the differences between CPI and PCE which will eventually lead us to why specifically the Core PCE is the preferred barometer for inflation (over headline and core CPI and over headline PCE).
Stick with me here and lets have a look at CPI vs PCE first…
CPI Vs PCE - Main differences?
Consumer Price Index: CPI is a metric that follows a fixed basket of goods. This fixed basket of items is measured month to month providing a consistent “basket of goods” cost for the common urban consumer. This allows for the basket of items to remain relatively unchanged thus providing an indication of how costs may be increasing or decreasing for the common consumer using the said basket (the basket is updated but not a frequently as the PCE basket).
Personal Consumption Expenditures: PCE includes a broader range of goods and services, and it is based on more frequent updates to the basket of goods and services that represent consumer spending, thus PCE captures more of the trend or trend changes in consumer spending. PCE includes expenditures on durable goods (e.g., cars and appliances), nondurable goods (e.g., food and clothing), and services (e.g., healthcare and education). This breakdown provides insights into which sectors of the economy are experiencing changes in consumer spending. We covered Durable Goods in a prior Macro Monday (I will link same under the published version on my TradingView). The bottom line on PCE is that it is more broader and more consumer led report thus arguably providing a more accurate indication of the wider spending habits of the consumer
Headline Vs Core (for both CPI and PCE)
In general Headline CPI and Headline PCE have an all-encompassing basket of goods and services included whilst Core CPI and Core PCE focus on a subset by excluding the volatile components of food and energy.
Analysts and policymakers often consider both Headline and Core to gain a comprehensive understanding of inflation trends, however Core PCE in particular provides the deepest and broadest insights into consumer led spending habits and provides the true underlying inflation by removing volatile commodities (Food & Energy). Lets look at CORE PCE a more closely
What is the benefit of excluding food and energy from inflation figures for Core PCE and why is this so beneficial?
1. Reduced Volatility: Energy and food prices are known to be more volatile and subject to temporary fluctuations due to factors such as weather conditions, geopolitical events, and supply chain disruptions. By excluding these components, Core PCE aims to provide a more stable measure of inflation.
2. General Inflation Trend Focus: As noted above, the short-term volatility in energy and food prices can mask the underlying aggregate trend in other goods and services, so the PCE eliminates some of this short term noise from food and energy inflation figures.
3. Captures Persistent Underlying Inflation Forces: Core PCE filters out the impact of temporary shocks to energy and food prices. This can be valuable for assessing whether inflationary pressures are becoming ingrained in the economy in the general sense.
4. Long Term Planning for the Consumer and the Fed: Understanding the underlying inflation trend is crucial to knowing the base level of the cost trend. Core PCE can provide a more reliable gauge for long-term economic planning by smoothing out short-term fluctuations.This provides investors, consumers and the Fed with a sort of long term general expenditure based moving average (the Core PCE) for the underlying inflation burden that is trending in an economy. All three participants can make the necessary adjustments to cater to this long term trajectory and thus the metric is a powerful tool for all involved.
Now that we know why the PCE is such a useful metric we can have a look at the long term PCE chart and see how things have been trending.
For the record CPI already came out for the month of November as CPI is typically released mid-month whilst PCE is released towards the end of the month.
Remember we will have an update this Friday from the BLS on the November readings for Core and Headline PCE, so we can see how we are looking then.
The Core and Headline CPI Chart
This CPI chart illustrates the following:
▫️ You can clearly see how Core CPI is less volatile than Headline CPI. As discussed above, Core CPI removes the volatile food and energy expenditures to provide a more general view of underlying inflation (based on a fixed basket of goods)
▫️ It is clear that we are not at the Federal Reserves target of 2% which is also outlined on the chart (purple line). It is critical to understand that we are still not at or below the target 2% level regardless of the FOMC’s determination of a likely hold on interest rates and reductions to interest rates in 2024. Lets see can the target be met first.
▫️ You can see that since 2002 Core CPI has fluctuated one standard deviation above and below the 2% inflation level between 1% and 3%. It is clear that we are not back into this standardized zone between 1 – 3%.
The Core and Headline PCE Chart (SUBJECT CHART AT TOP PROVIDED TODAY)
(will be updated this with newly released figures this Friday 22nd Dec)
This CPI chart illustrates many of the same findings from the CPI chart above:
▫️ Core PCE provides the deepest and broadest insights into consumer led spending habits versus a more fixed and stringent basket of goods for CPI, making Core PCE the Feds favorite inflation barometer to watch.
▫️ You can clearly see how Core PCE is less volatile than Headline PCE. As discussed above, Core PCE removes the volatile food and energy expenditures to provide a more general view of underlying inflation (based on a fixed basket of goods).
▫️ It is clear that we are not at the Federal Reserve’s target of 2% which is also outlined on the chart (purple line). The Federal Reserve have advised that Core PCE is expected to decline to 2.2% by 2025 & finally reach its 2% target in 2026. Anything that happens to interfere with this between now and then will need to be addressed by the fed.
▫️ You can see that since 1991 Core PCE has fluctuated one standard deviation above and below the 2% inflation level between 1% and 3%. It is clear that we are not back into this standardized zone between 1 – 3%.
Summary
You can visualize on the charts why the Core CPI and Core PCE is more important to Chair Powell, both Core metrics on the charts are almost like a slower moving average providing an indication of the longer term inflation trend. Right now Headline metrics are diving down past the Core metrics and the Federal Reserve cannot just take that volatile headline figure to make long term decisions. The Core PCE/CPI provides the long term trend trajectory whilst the Headline can offer early/lead signals of the direction of inflation, however core must be observed to determine the resilience of the long term trend. Furthermore, Core PCE is perceived by the FED as having more value as it has its finger on the pulse of the consumers spending habits by covering a broader range of expenditures whilst also accounting for consumer led spending trends. The CPI basket of goods in more fixed/restricted in terms of the goods it accounts for. This is why the FED values Core PCE so highly as a versatile and all encompassing gauge of inflation.
Hopefully you’ve come away today with a greater understanding of why the Core CPI and PCE data is preferred by the Fed ahead of headline inflation and also why the Core PCE comes out ahead as the chosen long term inflation gauge.
Any questions or observations, please throw them into the comments and I will be onto them as quickly as possible,
Thanks for reading,
PUKA
