Thoughts

February 16, 2024 | 13:47

Mind the (Inflation) Gap: CPI vs. PCE

Economist

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Will the real U.S. inflation report please stand up. A chunky 0.4% rise in core CPI prices held the yearly rate at 3.9% in January. And, the eye-popping 0.8% spike in core services prices (ex-rents) suggests stickiness in labour-intensive industries still struggling with worker shortages. Meantime, the Cleveland Fed’s trimmed-mean and weighted-median CPI measures both rose 0.5% last month, suggesting the leap in core prices wasn’t related to a few anomalies that are poised to retrace next month. An unwelcome jump in core producer prices only piled onto the bad news. True, one month doesn’t make a trend; and, as Scott explains, some of January’s spike could be reversed in coming months. But the fact of the matter is that, even if core goods continue to deflate, the Fed’s price stability goal could prove elusive unless service costs cool down much further.

But wait, you say, the Fed doesn’t target the CPI but the more comprehensive PCE deflator, which has decelerated rapidly. In fact, core PCE prices rose an annualized 1.9% in the second half of 2023, or a tick below the target. On a yearly basis, the core PCE deflator moderated to 2.9% in December, a full percentage point below the core CPI rate. Even if prices rise 0.3%-to-0.4% in January, the yearly rate could edge down a tenth or two due to an easy comparison last year. The gap between the two core inflation measures could widen to 1.2 ppts—the largest in over 22 years and three times the long-run median (of 0.42 ppts going back to 1960).

The PCE deflator tends to run slower than the CPI largely because of substitution effects, as shoppers often swap faster-rising items for slower-moving ones. Note in Chart 1 that the gap tends to widen in high-inflation periods. This gap reflects a mix of different weights on spending categories, different items within categories, and diverse methods of measuring price changes. To help explain the source of the 1.0-ppt spread between the two core measures in December (more than twice the norm), it’s best to focus on the two categories—rent and health care—that have the biggest weight difference (by far) and often the biggest variation in price movements.

Primary rent and owners’ equivalent rent account for a combined 43% of the core CPI (as of December 2022), and their 6% rise in the following year added a hefty 2.7 ppts to core CPI inflation in December 2023. By comparison, rent accounts for a smaller (though still large) 17% share of the core PCE deflator, and a mild 1% rise last year added just 0.2 ppts to core PCE inflation. The net 2.5-ppt contribution of rent to the core rate gap was partially offset by a negative 1.0-ppt contribution from health care. This reflected the larger weight of health care in the core PCE deflator (22.1% versus 10.1%), combined with a faster increase (about 6%) in medical costs compared with a much milder 0.5% rise in the CPI. Together, rent and health care accounted for a net 1.5 ppts of the gap in the two core rates; i.e., more than all of it. Without these two heavyweights, core PCE inflation likely would be above the core CPI rate in December. Then again, excluding shelter, core CPI inflation would also be much lower than it currently is; in fact, just 2.2% in December and January, according to the BLS.

Bottom Line: As rent growth moderates this year, inflation should ease further. But sticky services costs, even beyond shelter, suggest the decline—regardless of the survey—will be gradual. This means the Fed might not attain “greater confidence that inflation is moving sustainably toward 2 percent” until the summer, thereby delaying rate cuts until the 2024 Olympics are underway.