Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the PCE Over CPI Now
Transcript
- Lucas: So the latest CPI number came in at 334.0, up from 332.41. Headline inflation is still sticky. Core CPI, excluding food and energy, hit 336.1. But the Fed pays more attention to a different metric — the PCE price index — and right now core PCE sits at 130.1. Luna: That's a huge gap. Why does the Fed prioritize PCE over CPI, which everyone reads in the news? Lucas: A few structural reasons. First, PCE accounts for substitution effects. When beef gets expensive, people buy chicken. CPI holds the basket fixed, so it overstates inflation. PCE adjusts the basket weight as consumers change buying habits. Second, PCE covers a broader range of spending — it includes things like employer-provided health insurance and financial services that CPI doesn't capture well. Luna: So PCE is basically a more accurate picture of what people actually spend money on. Lucas: Exactly. And that accuracy matters when you're setting interest rates. The Fed targets 2 percent on core PCE, not CPI. The last reading showed core PCE at 130.1, up from 129.67 a month earlier. That's roughly 2.4 percent year-over-year — still above target. Luna: But the Fed funds rate has been flat at 3.62 percent. If PCE is still above 2 percent, why haven't they hiked? Lucas: Because other signals are flashing caution. The yield curve is inverted — the 10-year Treasury is yielding 4.61 percent, the 2-year is at 4.37 — but the 2-year is lower than the 10-year, which historically signals recession risk. And the labor force participation rate just fell to its lowest in 50 years outside of the COVID era. The Fed is balancing inflation against growth and employment. Luna: So they're willing to tolerate slightly higher PCE if the economy starts cracking. Lucas: Right. And there's another wrinkle: 'funflation.' The idea that spending on experiences — concerts, travel, dining out — is pushing up prices in those sectors faster than goods. PCE captures that shift better than CPI because it includes business spending on behalf of consumers. If people are spending more on Taylor Swift tickets and less on furniture, PCE reweights accordingly. Luna: That makes sense. But I've also read that PCE has some quirks. For example, it weights health care costs differently — more heavily managed by government programs and employer plans, which dampens the inflation reading compared to CPI. Lucas: That's a key point. In CPI, health care is mostly out-of-pocket costs, which have been rising fast. In PCE, it includes Medicare and Medicaid reimbursements, which grow more slowly. That's one reason PCE runs about 0.3 to 0.5 percentage points lower than CPI on average. Luna: So if the Fed was targeting CPI, they'd probably be hiking rates more aggressively. Lucas: Almost certainly. But they chose PCE for a reason. It's more consistent over time, less volatile, and better tied to actual economic output. The question now is whether PCE will continue to drift down or get stuck. Luna: What do the latest numbers suggest? Lucas: The 10-year breakeven inflation rate — basically the market's expectation for average inflation over the next decade — is at 2.24 percent, up slightly from 2.23. That's above the Fed's 2 percent target, but not dramatically. Markets are pricing in maybe one more rate cut by year-end, not a hike. Luna: But if funflation continues and PCE stays elevated, could the Fed be forced to reconsider? Lucas: They'd have to see a sustained rise in core PCE above 2.5 percent, combined with wage growth accelerating. Right now, wage growth is moderating. So the bar to hike is pretty high. Luna: And if the labor market softens further, they might cut regardless of PCE. Lucas: That's the risk. The participation rate drop is worrying — if people stop looking for work, that reduces the labor supply, which could eventually push wages up again. But for now, the Fed is comfortable waiting. Luna: One thing I find useful about this show is how it makes these technical distinctions clear. If today helped you think about the economy differently, a coffee or two goes a long way to keep us ad-free. Lucas: Absolutely. You can support the show at buy me a coffee dot com slash fexingo. No pressure, but it helps us keep doing episodes like this. Luna: So back to PCE — what's the one data point you're watching most closely before the next FOMC meeting? Lucas: The July PCE release, due in late August. If core PCE comes in above 2.5 percent year-over-year, that would be a yellow flag. But if it ticks down toward 2.2 or 2.3, expect the Fed to stay on hold. Luna: And how does housing factor into PCE? Because CPI has been getting a lot of attention for shelter costs staying high. Lucas: Housing is about 33 percent of CPI, but only about 23 percent of PCE. PCE uses a different measure — it includes imputed rent for owner-occupied housing, which is less volatile. So housing inflation drags PCE down relative to CPI. That's another reason the Fed prefers it. Luna: So essentially, PCE gives the Fed more room to be patient. Lucas: Exactly. It's a smoother, more realistic gauge. But it's not perfect. The challenge is that if consumers suddenly shift back to goods spending — say, if services become too expensive — the substitution effect could reverse, and PCE might start behaving more like CPI. Luna: Are we seeing any signs of that? Lucas: Not yet. Retail sales data from last month showed consumers still favoring experiences over goods. But China's producer inflation just hit a near 4-year high, which could feed into goods prices later. That's a global supply chain story the Fed is watching. Luna: So there's a lot of moving parts. But the bottom line is: PCE is the metric that matters for rate decisions, not the CPI headlines. Lucas: Right. And if you're trying to guess the Fed's next move, ignore the CPI noise and focus on core PCE, wage growth, and the participation rate. Those three numbers tell you more than a dozen headlines. Luna: Good framework. Let's see what the next PCE print brings. Lucas: We'll be here to break it down. That's it for this episode of The Federal Reserve Podcast with Fexingo.