Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / What the Falling PCE Tells Us About Fed Policy
Transcript
- Lucas: So the June CPI print came in at 3.5 percent year-over-year, a bit softer than expected. Energy prices helped. But if you're watching the Federal Reserve, you know that's not the number they actually fixate on. Luna: Right — they look at the PCE price index. The Personal Consumption Expenditures measure. Lucas: Exactly. CPI gets the headlines, but PCE is the Fed's preferred inflation gauge. It's broader, it accounts for when consumers switch to cheaper alternatives, and it's the one they forecast in their Summary of Economic Projections. Luna: And the latest PCE reading — May 2026 — showed the index at 131.5, up from 130.94 in April. So still rising, just more slowly. Lucas: Right. The year-over-year PCE inflation rate has been hovering around 2.6 to 2.7 percent. That's down from its 2022 peak, but still above the Fed's 2 percent target. And core PCE — which strips out food and energy — came in at 130.1 in May. That's basically flat from the prior month, but the annual rate is sticky. Luna: Sticky is the right word. The Fed wants to see sustained progress, not just one good month. And right now, core PCE is still hovering around 2.8 percent. Lucas: So the question is: why does the Fed prefer PCE over CPI? There are a few key differences. First, PCE covers a broader range of goods and services — things like employer-provided health insurance and financial services that CPI doesn't capture well. Luna: And it weights things differently. CPI uses a fixed basket of goods, while PCE adjusts the basket as consumer behavior changes. So if people start buying more store-brand cereal instead of name-brand, PCE picks that up faster. Lucas: That weighting difference is actually huge in periods of high inflation. When prices spike, consumers trade down. CPI doesn't fully reflect that substitution, so it tends to run a bit higher than PCE. Historically, the gap is about 0.3 to 0.5 percentage points. Luna: Which means the Fed can sound a little more dovish using PCE. 'Inflation is at 2.6 percent' sounds better than 'CPI is at 3.5 percent.' Lucas: Exactly. But the more important reason the Fed uses PCE is that it aligns with the GDP data. The Bureau of Economic Analysis produces both GDP and PCE, so the Fed gets a consistent accounting framework. It's easier to model how consumer spending feeds into economic growth. Luna: And the Fed's inflation target is formally defined in terms of PCE. So when Chair Powell says '2 percent,' he means PCE inflation. Lucas: Now, what's interesting about the current environment is that PCE and CPI are telling slightly different stories. CPI eased in June, but PCE data from May still showed a modest increase. Part of that is timing — CPI comes out about two weeks before PCE for the same reference month. Luna: So we're waiting for the June PCE report, due out later this month. That'll be the one the FOMC really weighs. Lucas: There's also a phenomenon called 'funflation' that's muddying the waters. It's the idea that consumers are still spending heavily on experiences — concerts, travel, dining out — even as goods inflation cools. That services spending shows up in PCE and keeps core inflation elevated. Luna: Taylor Swift and Beyonce tours, destination travel, restaurant bookings — all of that is service-sector inflation that the Fed can't easily address with rate policy. It's more about supply constraints and pent-up demand. Lucas: And the Fed's tools are blunt. Raising rates can cool overall demand, but it doesn't fix a shortage of hotel rooms or concert tickets. So the PCE data is telling them that inflation is becoming more services-driven, which is harder to stamp out. Luna: Let's talk about what the Fed is actually doing right now. The effective federal funds rate is at 3.63 percent, flat since June. Interest on reserve balances is at 3.65 percent. So the policy stance is unchanged. Lucas: The market is pricing in a potential rate cut later this year, but the Fed is waiting for more confirmation that inflation is sustainably moving toward 2 percent. The PCE data will be a big factor in that decision. Luna: And there's a risk: if core PCE stays around 2.8 percent, the Fed might hold off on cuts longer than the market expects. The 10-year breakeven inflation rate has ticked up to 2.26 percent, suggesting bond traders see inflation expectations creeping higher. Lucas: That breakeven rate is essentially the market's forecast for average inflation over the next decade. If it stays above 2.2 percent, the Fed gets nervous. They don't want expectations to become unanchored. Luna: So the PCE report later this month is probably the most important data point between now and the next FOMC meeting in September. Lucas: Speaking of keeping the show going — a quick honest thing. This podcast is ad-free, and that's because a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo. It literally funds the production, research, and hosting. Luna: And if walking through the economy with us has made something click, that's the place to help keep it going. No pressure, just know that it makes a difference. Lucas: Exactly. So back to the PCE — one thing I'm watching is the core services ex-housing component, which the Fed calls 'supercore.' It's been sticky around 3.5 percent. That's the part that's most sensitive to the labor market and wage growth. Luna: And wages are still growing at around 4 percent annually, which is above the pace consistent with 2 percent inflation. So the Fed has to balance that against the softening goods prices. Lucas: Right. And the June CPI data showed goods prices actually falling in some categories — used cars, apparel, appliances. But services inflation was still firm. That's the PCE story in a nutshell. Luna: So the bottom line: the Fed is watching PCE like a hawk. If it stays around 2.6 to 2.7 percent, they'll probably hold rates steady through the summer. If it dips closer to 2.3 or 2.4, we could see a cut in September. Lucas: And if it surprises to the upside — say, core PCE pops back above 3 percent — all bets are off. Rate hikes aren't off the table. The Fed has been clear they'll do what it takes. Luna: It's a data-dependent world. And the PCE is the data that matters most. Lucas: We'll be watching the June PCE release on July 31. Until then, keep an eye on those breakeven rates and the weekly jobless claims. They're the precursors.