The Fed uses one inflation gauge as its North Star. Here’s why

On Jan 28, 2022

Federal Reserve Chairman Jerome Powell speaks during his re-nomination hearing before the Senate Banking, Housing and Urban Affairs Committee on Jan. 11, 2022 in Washington.

Brendan Smialowski-Pool/Getty Images

The Federal Reserve is expected to raise interest rates soon from rock-bottom levels to cool inflation.

The Personal Consumption Expenditures Price Index jumped by 5.8% in December from the year prior, tied for the fastest pace since June 1982, the Bureau of Economic Analysis said Friday.

Fed officials prefer this inflation metric over others as the North Star guiding their policy response. The U.S. central bank uses it to grade whether it’s on track to hit its 2% inflation target, according to economists.

But why is this the preferred gauge?

Broad scope

Like the perhaps-better-known Consumer Price Index, the PCE Price Index reflects the prices Americans are paying for a basket of goods and services, and how those costs change over time.

But the barometers differ in two key ways.

For one, the PCE Price Index has a broader scope than its CPI cousin.

The latter looks at households’ out-of-pocket costs, while the PCE Price Index examines a broader swath of the cost ecosystem, according to economists.

Take health care, for example: The PCE Price Index accounts for costs incurred by government programs like Medicare and Medicaid, as well as private insurers, where CPI does so just for health costs that directly impact Americans’ wallets, according to Josh Bivens, research director at the Economic Policy Institute.

“The larger scope is one virtue [of the PCE Price Index],” Bivens said.

“When the Fed is looking at inflation, they’re less concerned with what is happening to the living standard of the household; they want to know the macroeconomic inflationary pressure building up,” he added.

The Federal Reserve looks primarily at “core” prices, which strip out volatile food and energy categories. That PCE Price Index gauge jumped 4.9% in December from a year earlier, the biggest gain since September 1983.

Consumer behavior

The PCE Price Index is also more dynamic, economists said. It better reflects how prices affect consumer behavior and how households respond to rising costs.

If beef prices rise significantly, families may instead buy chicken to defray costs, for example.

The CPI does this, too, but much more slowly — about every two years instead of each quarter, Bivens said.

That’s why CPI tends to overstate the rate of inflation — it assumes people buy the same things in years one and two without accounting for substitution bias, according to Marc Goldwein, senior director of policy at the Committee for a Responsible Federal Budget.

Indeed, inflation jumped 7% in December as measured by the CPI, relative to the 5.4% for the PCE Price Index.

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