Having more than one criterion helps to have a better view of the state of prices, but at the same time it can bring problems and this is what could happen to the US Federal Reserve in the coming months. Traditionally, the most scrutinized central bank on the planet has its “fetish” inflation indicator: the so-called core PCE, a deflator of personal consumption spending that excludes energy and food. But the inflationary escalation experienced at the end of the pandemic made many eyes turn to the consumer price index (CPI) in the media. Among these eyes is specifically that of the Fed, which threatens to bring more headaches to the body chaired by Jerome Powell. The predictable drop in housing will be blamed, which will drag down the CPI (where real estate has a lot), compared to the PCE (where housing is much less represented).
While traditionally the CPI registers higher readings than the PCE, in recent months this difference has widened to 1.7 percentage points. In January the ‘mouth’ was reduced by a still considerable percentage point. Continuing with the recent ratio, an overall CPI of 2.8% in October, which is what the market is betting on (the reading for January was 6.4%), would correspond to an overall PCE of 2.5% so far . (In January it was 5.4%), calculates Michael Pond, chief inflation research analyst at Barclays. The Fed’s 2% inflation target would be in range.
Although, the problem for 2023 stems from the different weighting of the categories that make up each index, which would strongly reverse the dynamics experienced in 2022. The difference in weight that each indicator gives to the components will cause the PCE -‘fetish’ of the Fed- to fall more slowly than the CPI -neon lights for the market-. This will cause a dangerous disconnect: the market will see inflation close to being controlled and the Fed will be isolated having to continue transmitting rigidity. Barclays’ Pond forecasts that the PCE will increase by around 2.8% year-on-year in October, while the CPI advance will slow to 2.6%, which shows the open gap.
Worse and in the short term is painted by Veronica Clark, an economist at Citi, who sees the CPI at 3.2% in June, with PCE around 3.6% that month. The divergence will be accentuated, according to this analyst, in the index cores: the CPI core would be 3.8% in December (in January it was 5.6%) and the PCE core would be 4.3% (in January was 4.7%).
“That will leave market participants looking at low inflation while the Federal Reserve looks at a move that tells them they should remain very aggressive,” explains Pond. “The Fed goes a big dilemma at hand from a communication standpoint.” “For the Fed, the message can be a little tricky,” cautions Clark. “They’re targeting the PCE, technically, as long as the PCE stays high, they can’t declare victory.”
At this point, two questions arise: what are the differences between one inflation measure and another to reach this point and why choose one or the other. The main difference between the two indices is the place of life (it has a weight of almost 40% in the CPI, against 20% in the PCE)… and housing is under pressure in the US. After years of sharp price increases in the heat of historically low interest rates, the real estate market has begun to cool down and even correct itself. Official data speaks of a drop in average US home sales prices of more than 2% (quarterly) in the last quarter of 2022. This trend should continue in the coming months, especially if the Fed continues to press the accelerator rate rises , something that is getting closer and closer. Some analysts are already betting on a terminal rate of 6%.
After a short break for a few weeks in January and February, mortgage rates have risen again in the US and are now above 6.65% again. “Consequently, the US housing market has gone from a glut of demand, which drove prices up by 40% nationally between early 2020 and summer 2022, to one where supply now exceeds demand. Unsurprisingly, this now is having an impact on prices, as all major US cities have experienced declines in home prices, according to S&P Case Shiller home price data.
Thus, compared to what happened in 2022 (taking into account the delay with which some housing data are incorporated into the IPC), the expectation is that housing will help to deflate the IPC and generate a mirage for the markets. Investors may mistakenly believe that this CPI drop will translate into a less tough Fed, when the truth is that the central bank will be keeping an eye on the PCE and other ‘broader’ inflation indicators, which have yet to show signs of easing. Furthermore, if the last monthly PCE value is annualized, the rate is dangerously close to 8%. Although this is an exercise in science fiction, Americans attach great importance to the annualization of data.
The Fed itself placed special emphasis in disclosure articles on the different weightings of the CPI and the PCE. While there are other factors that differentiate these two price indicators, this is perhaps the most important to consumers and investors: “The relative weights assigned to each of the CPI and PCE item categories are based on different sources and are primarily based on in the Encuesta de Gastos del Consumer, a household survey conducted by the Office of Labor Statistics.” Here, the goods and services that have the greatest representation in the consumer’s shopping basket weigh above all weight.
On the contrary, the goods and services that enter the PCE are broader, include a wider range of products, but do not faithfully represent the typical consumer shopping basket: “The relative weights used in the PCE index are derived from business surveys, for example, the Census Bureau’s annual and monthly Retail Trade Surveys, the Annual Services Survey, and the Quarterly Services Survey.
“This means that the expected disinflation that in the coming months will come from falling rents will be less pronounced in the PCE readings than in the CPI readings. For the same reason, the inflation of basic services excluding housing (a measure praised by Powell recently), which accounts for about 75% of the PCE basket against 40% of the CPI, it can be more complicated when using the PCE numbers”, adds Edoardo Campanella, analyst at UniCredit Research.
Why will the Fed listen -in theory- to the PCE? James Bullard, chairman of the St. Louis, explained some time ago in a technical note that “the federal government prefers to use the CPI to adjust for inflation certain types of benefits, such as Social Security. On the contrary, the FOMC (The Fed) focuses on PCE inflation in its projections quarterly economic forecasts and also sets its long-term inflation target in terms of the PCE for three main reasons: spending weights in the PCE can change as people substitute some goods and services for others, the PCE includes broader coverage of goods and services, and historical PCE data may be revised (in addition to seasonal factors).”
“The FOMC carefully evaluated both indexes to see which metric to use (for inflation targeting) and concluded that PCE inflation is the best measure. In my opinion, the PCE headline should become the standard and therefore “should be used consistently to estimate and adjust for inflation. While adopting a standard measure is likely not to be a simple matter, it would provide clarity to the public as to which one most accurately reflects consumer price inflation,” Bullard said at the time.
But the recent past has been tumultuous, as Paul Donovan, a strategist at UBS, has lamented in repeated analyses. “The CPI in the US is not a cost-of-living index and says little about the real-world experience of most American households: the largest component is an entirely made-up value. However, it fixes the indexing of tax brackets and large part of US public spending. June’s Big Mistakes Federal Reserve Chairman Powell highlighted the importance of consumer prices to monetary policy,” he noted in a January commentary.
The mistake, according to Donovan, was showing the CPI: “It’s volatile, so focusing on it will make markets volatile.” Precisely, the “invented” figure corresponds to housing: “Most of the CPI is the fantasy equivalent rental amount of Owners (OER), which nobody really pays.