What Are the Key U.S. Inflation Indicators? How Does CPI Affect the PCE Index?

TradingKey - Price stability and maximum employment are the dual mandates of the Federal Reserve. The Fed manages liquidity in the financial system through interest rate hikes or cuts, thereby influencing capital markets. When discussing U.S. inflation, the CPI (Consumer Price Index) and PCE (Personal Consumption Expenditures Price Index) are considered the two most important indicators for measuring consumer inflation.

While different countries may measure CPI differently, overall, CPI is the most widely accepted inflation indicator. However, for Federal Reserve policymakers, the PCE index is the key inflation data to monitor.

Overview of Major U.S. Inflation Indicators

There are many indicators used to assess U.S. inflation trends. They can be categorized into:

• Consumer vs. Producer Inflation
• Headline vs. Core Inflation
• Survey-based vs. Market-based Inflation
• Service vs. Goods Inflation, etc.

They also include supplementary metrics such as inflation expectations.

Among official releases, the most closely watched indicators are CPI and PCE —with the latter often referred to by media as “Fed’s Preferred Inflation Gauge.”

Source: TradingKey

Official inflation surveys conducted by U.S. government agencies often come with lags. For example, CPI may not capture the latest price fluctuations in a timely manner. Therefore, some inflation expectation indicators can provide auxiliary guidance for forecasting inflation trends. These include survey-based inflation expectations and market-implied inflation indicators.

Survey-Based Inflation Expectations

Source: TradingKey

Market-Based Inflation Expectations

Source: TradingKey

There are complex interlinkages among various U.S. inflation indicators. For instance:

• Producer-side pressures → PPI → passed through to CPI → eventually affecting the PCE index
• Employment cost (ECI) → service sector inflation → core PCE index
• Consumer expectations (e.g., Michigan Inflation Expectation) → actual consumption behavior → CPI or PCE index

Differences Between CPI and PCE

The U.S. CPI and PCE index are the most closely followed inflation indicators in financial markets. Specifically, CPI is favored by Wall Street while PCE is the Fed’s preferred metric.

Both CPI and PCE are monthly data releases from official U.S. agencies, with CPI typically released before PCE. They differ in terms of calculation methods, coverage, component weights, and economic impact.

1. Issuing Agencies and Data Sources

• CPI: Published by the Bureau of Labor Statistics (BLS); measures price changes in a basket of goods and services purchased by urban households; based on household surveys and retail pricing samples.
• PCE: Published by the Bureau of Economic Analysis (BEA); measures price changes in total personal and institutional consumption expenditures nationwide.

2. Calculation Methods

• CPI: Laspeyres index; uses a fixed basket that ignores substitution effects; basket updated every two years; higher weights given to housing, food, and healthcare.
• PCE: Fisher Ideal index; uses a variable basket that accounts for consumer substitution; weights adjusted monthly; includes healthcare expenditures paid by employers and governments, with significant weightings on housing, food, and healthcare.

3. Long-Term Characteristics and Influence

• CPI: More volatile; tends to show higher inflation readings; receives more media attention and public awareness.
• PCE: Less volatile; the Fed’s primary inflation metric; directly linked to GDP calculations.

Studies have shown that historically, the annual growth rate of CPI has been systematically higher than that of PCE. This discrepancy arises from formula effects and weighting effects inherent in their methodologies.

• Formula Effect: PCE accounts for substitution behavior, where consumers switch to cheaper alternatives when prices rise.
• Weighting Effect: CPI assigns higher weights to housing and energy, which are more price-sensitive.

The idea that PCE is the Fed’s preferred inflation indicator dates back to 2000. In February 2000, the Fed proposed shifting its focus from CPI to PCE to address the bias caused by CPI’s fixed-weight approach.

Reasons why PCE is better suited for economic analysis include broader coverage (both consumers and businesses), consideration of substitution behavior, a variable basket, and lower volatility.

In summary:

• CPI is a "cost-of-living index" from the consumer’s perspective and has stronger resonance with public perception due to earlier release times.
• PCE serves as a "consumer inflation index" from a macroeconomic policy perspective and is more suitable for guiding monetary decisions.

How Does CPI Affect PCE?

Although CPI and PCE are calculated differently and may sometimes diverge in trend, there are indeed linkages and transmission mechanisms between them. The earlier release of CPI can influence PCE through price linkages, changes in consumer behavior, and shifts in inflation expectations.

Source: Cleveland Fed

1. Direct Transmission: Price Component Correlation

CPI and PCE share many overlapping categories—such as housing, energy, food, and healthcare—though with differing weights. When prices in CPI components rise or fall, similar movements may occur in PCE.

For example, during the first half of 2022, the Russia-Ukraine conflict caused oil prices to surge. In June 2022, the CPI energy component rose 41.6% YoY, while the PCE energy component increased by 35.8%. However, because energy carries less weight in PCE, overall PCE rose only 6.8%, compared to CPI’s 9.1%.

Historical data and weight distribution differences suggest that high-weight items in CPI (like energy and housing) have limited impact on PCE. Food substitution effects are pronounced, and policy-sensitive sectors like healthcare may cause long-term divergence between CPI and PCE.

2. Indirect Transmission: Substitution Effects and Consumer Behavior Changes

Since CPI uses a fixed basket while PCE uses a variable one, if the price of a certain item in CPI rises sharply, consumers may switch to cheaper substitutes. This behavioural shift means CPI may overstate inflation, whereas PCE reflects a more accurate, lower level of inflation.

For example, if beef prices included in CPI soar, consumers may switch to chicken. The PCE index adjusts accordingly to reflect this change in consumption patterns.

3. Expenditure Shifts: Business Pricing and Policy Expectations

Earlier-released CPI reports can affect corporate operations. If CPI shows accelerating price increases, companies may raise prices, increasing consumer spending and pushing up the PCE index.

Additionally, if CPI continues to rise, expectations for Fed rate hikes increase, potentially dampening consumer activity and slowing PCE growth.

How to Trade Inflation Data?

Historically, the U.S. experienced painful high inflation in the 1970s. Both the Biden administration and the potential Trump 2.0 administration continue to grapple with persistent post-pandemic inflation driven by ultra-loose monetary policy.

In theory, persistently high inflation increases the likelihood of Fed rate hikes, while falling inflation or deflation risks prompt rate cuts. The Fed’s adjustments in monetary policy stance influence capital markets through changes in financial system liquidity.

Therefore, “trading inflation data” essentially involves trading expectations about the health of the U.S. economy and potential shifts in the Fed’s monetary policy stance.

Besides YoY and MoM growth rates, the deviation between actual data and market expectations is a key basis for investors in stocks, bonds, and forex markets to adjust positions.

Market Reactions Based on Inflation Readings:

• Higher-than-expected inflation: Buy USD, Sell U.S. equities, Sell bonds
• Lower-than-expected inflation: Sell USD, Buy U.S. equities, Buy bonds

Market volatility is influenced by multiple factors. Investors should also pay attention to prior values, revisions, immediate market reactions after data releases, and comments from Fed officials regarding inflation and economic outlook.