Just What Is The PCE, Anyway?

Inflation is a crucial factor in the financial world, influencing everything from interest rates to stock market performance. Wall Street keeps a close eye on various inflation measures, but one, in particular, garners the most attention: the personal consumption expenditures (PCE) price index.

Below, I explain why the PCE inflation price index looms large on Wall Street, why the Federal Reserve prefers this gauge, and why it’s considered a better indicator than the more popularly known consumer price index (CPI).

But first, let’s take a look at the latest PCE release and what it portends for the financial markets.

Inflation during May decelerated to its lowest annual rate in more than three years, the U.S. Bureau of Economic Analysis (BEA) reported on Friday.

The core PCE price index last month increased a seasonally adjusted 0.1% for the month and was up 2.6% from 12 months ago, the latter number down 0.2 percentage point from the April level (see chart).

Both numbers were in line with consensus estimates. May marked the lowest annual rate since March 2021.

Including food and energy, headline inflation was flat on the month and also up 2.6% on an annual basis. Those readings were in line with expectations.

In addition, the BEA report showed that personal income rose 0.5% on the month, stronger than the 0.4% estimate. Consumer spending, however, increased 0.2%, weaker than the 0.3% forecast.

These latest inflation numbers showed that inflation is continuing its downward trajectory, paving the way for further monetary easing.

The Fed’s Preferred Inflation Gauge

The financial media glibly refers to the PCE but rarely explains exactly why it’s so important. Knowledge is power, so let’s look under the hood of this widely cited and highly influential indicator.

The PCE price index measures the average change over time in the prices paid by consumers for goods and services. It is a comprehensive and dynamic measure, reflecting changes in consumer behavior and the composition of consumption.

The index is divided into two categories: headline PCE, which includes all items, and core PCE, which excludes food and energy prices due to their volatility.

Wall Street pays close attention to the PCE price index for several reasons. First and foremost, it is the inflation gauge that wields the most clout with Fed officials.

Since the Fed’s monetary policy decisions significantly impact financial markets, understanding the PCE is crucial for investors. When the Fed evaluates inflation to guide its policy decisions, the central bank primarily considers the PCE price index, making it a critical indicator for investors.

Secondly, the PCE provides a more accurate and timely measure of inflation. Its methodology captures a broader range of expenditures and adjusts for changes in consumer behavior more effectively than other indices. This accuracy is vital for financial analysts and traders who rely on precise data to make informed decisions.

Here are key reasons why the Fed favors the PCE. These reasons, by the way, are almost never explained by the folks on television:

  • The PCE includes a wider array of goods and services, reflecting a more accurate picture of consumer spending.

The PCE covers expenditures by and on behalf of households, including medical services paid for by employers or government programs, which the CPI does not fully capture.

  • The PCE accounts for changes in consumer behavior and the substitution effect.

When prices rise, consumers may shift their spending to less expensive alternatives. The PCE adjusts for these changes, providing a more accurate measure of the cost of living.

  • The PCE uses a chained index formula, which adjusts for changes in consumption patterns over time.

This approach captures shifts in consumer preferences and the introduction of new products, resulting in a more dynamic and representative measure of inflation.

  • The weights in the PCE are based on current and past expenditure data, making it a forward-looking measure.

In contrast, the CPI weights are updated less frequently, leading to potential lags in reflecting current spending habits.

  • The PCE is based on actual reported expenditures, while the CPI relies on surveys of consumer prices.

This focus on actual spending data ensures a more accurate representation of inflation.

By excluding volatile food and energy prices, the so-called core PCE provides a clearer picture of underlying inflation trends. This stability is crucial for policymakers and investors who need to assess long-term inflationary pressures.

The Fed’s communication often references the PCE when discussing inflation targets and economic outlooks. Investors who comprehend the PCE’s implications can better interpret the Fed’s statements and align their portfolio strategies with anticipated policy moves.

The upshot of Friday’s PCE report: the Fed is all the more likely to cut interest rates before the year is out.

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This article previously appeared on Investing Daily.