Latest / Inflation Explained with Fexingo: CPI, Prices, and the Cost of Living for Everyday People / The PCE Index Gap Why Inflation Feels Different Than CPI
Transcript
- Lucas: So the April core PCE reading came out yesterday — 3.3 percent annualised, right in line with what economists expected. And yet, if you ask most people how they're feeling about prices right now, you'll hear something much closer to four, five percent or worse. Luna: That gap between the official number and the lived experience — it's been a theme across several of our episodes. But today we're zeroing in on why the Fed's preferred gauge, the PCE index, can diverge so much from the CPI that gets all the headlines. Lucas: Exactly. The Fed targets PCE, not CPI. And there are structural reasons why PCE tends to run a bit cooler — about 0.3 to 0.5 percentage points lower on average over the long run. But in this cycle, the gap has been wider, and it's worth understanding why. Luna: Let's start with the big one: housing. In CPI, rent and owners' equivalent rent make up about a third of the index. In PCE, housing is closer to 15 percent. Lucas: Right. That's a huge difference. And since housing has been one of the stickiest components — rents are still rising, even if the pace has moderated — CPI gets more upward pressure from that category. PCE dilutes it. So the Fed, looking at PCE, sees a slightly less alarming picture on shelter costs. Luna: Then there's healthcare. CPI captures out-of-pocket costs, insurance premiums, but it's a narrower basket. PCE includes things like employer-paid health insurance and Medicare reimbursements — which don't show up in CPI at all. Lucas: That's actually a big deal. Because healthcare costs have been rising faster than overall inflation, but the way PCE weights them — including those third-party payments — actually dampens the impact on the headline number. Critics say that makes PCE less representative of what consumers actually feel. Luna: And energy? Both indices include it, but the weights differ too. CPI gives gasoline a higher share because it's a direct consumer purchase. PCE spreads energy across more categories. Lucas: Yes. So when energy prices spike — which they have been, with the Iran situation and all — CPI feels it more immediately. PCE smooths it out a bit. That's actually by design: the Fed wants a measure that strips out some of that volatility, which is why they also focus on core PCE, excluding food and energy. Luna: But let's be real — consumers don't eat core inflation. They buy gas and groceries. So when the Fed says 'inflation is at 3.3 percent' based on PCE, but people are seeing 4 or 5 percent in their daily lives, that creates a credibility problem. Lucas: It does. And that's where the 'double scar' concept from the CNBC headline comes in. The memory of the 2021-2022 inflation spike is still very fresh. Plus now you've got geopolitical shocks — the Iran conflict, supply chain disruptions — that keep energy and food prices elevated. So even as the official numbers moderate, sentiment stays sour. Luna: I want to come back to that sentiment piece. But first — Lucas, you mentioned the Fed targets PCE. Are there any signs they might shift focus given this persistent gap? Lucas: Not really. The FOMC has used PCE since 2000, and they've repeatedly defended it as more comprehensive and less subject to upward bias than CPI. Kashkari's comments yesterday reinforce that — he said inflation fight takes priority, and the labor market is 'in decent shape.' They're not questioning the metric itself. Luna: But Goolsbee also said energy inflation has been more persistent than expected. So even their preferred gauge is showing stickiness in certain components. Lucas: Right. And that's the nuance. Core PCE at 3.3 percent is still well above their 2 percent target. The question is how much of that is transitory — tied to geopolitics — versus structural. If energy keeps feeding through, it eventually hits core categories too. Luna: Let's talk about that sentiment piece. The University of Michigan consumer sentiment index has been stuck at historically low levels for months, even as the economy adds jobs and GDP grows. Inflation perception is clearly a driver. Lucas: Yeah, and there's research showing that consumers' inflation expectations are heavily influenced by the prices they see most frequently — gasoline, milk, eggs, rent. Those have been volatile. So when the PCE line goes from 5 percent down to 3.3, but the price of eggs is still 40 percent higher than three years ago, people don't feel better. Luna: That's the 'level' versus 'rate of change' problem. Inflation could be cooling, but prices are still high. And that's not captured in any single number. Lucas: Exactly. The Fed is trying to manage expectations — they want people to believe inflation will keep falling. But if official metrics diverge from lived experience, that belief gets harder to sustain. Luna: And that divergence can feed into wage demands, which then feed into actual inflation. So it's not just a measurement issue — it has real economic consequences. Lucas: Before we go further — and this ties directly into what we're talking about — I want to mention something. If walking through the economy with us has made something click, a couple of dollars a month genuinely keeps these episodes ad-free and independent. It's at buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small thing that makes a real difference. We don't have sponsors, so listener support is what keeps us going. No pressure, just if you've gotten value. Lucas: Right. So back to the pce cpi gap. There's one more component I think is underappreciated: how each index handles substitution. CPI assumes a fixed basket of goods — the same stuff month after month. PCE updates its weights quarterly based on what people actually buy. Luna: So when beef prices spike and people switch to chicken, PCE captures that substitution effect and the overall index rises less. CPI doesn't, so it overstates inflation in those cases. Lucas: Precisely. That's one reason PCE tends to be lower. But critics argue that in periods of high inflation, substitution is a luxury — not everyone can switch to cheaper alternatives easily. So PCE might understate the pain for lower-income households. Luna: That's a really important point. The inflation rate you experience depends on what you buy. If you rent, commute by car, and don't have employer-sponsored health insurance, your personal inflation rate is probably higher than the PCE headline. Lucas: Right. And that's why you see these calls for the Fed to consider more disaggregated measures. Some economists have proposed a 'CPI for the bottom 20 percent' or targeted measures for different income groups. Luna: But the Fed isn't there yet. They're still looking at the aggregates. With the fed funds rate at 3.62 percent and holding, they're waiting for more data before making any moves. Lucas: Yeah, and the 10-year breakeven inflation rate is at 2.39 percent — basically flat. The bond market seems to think inflation is anchored, but not yet at target. That's consistent with the Fed's wait and see posture. Luna: So what's the takeaway for someone listening? How should they interpret the next PCE or CPI release? Lucas: I'd say: look at both. CPI tells you what's happening with out-of-pocket costs. PCE tells you what the Fed is using to set policy. If they diverge, that tension matters. And don't just look at the headline — look at the components. If housing is the main driver, that's different from energy or food. Luna: And keep an eye on the 'double scar' — past inflation trauma plus current geopolitical shocks. That combo is keeping sentiment fragile, which could eventually feed into wage demands and make the Fed's job harder. Lucas: Exactly. The official numbers are important, but they're not the whole story. For now, the Fed is holding steady, watching the data, and hoping that time — and maybe some luck on energy — brings those numbers down. Luna: And if they don't? What's the risk? Lucas: Then we could see the Fed forced to hike again, which would be a shock to markets. The S&P is at 7,581 — near all-time highs. A rate hike could rattle that. But for now, the base case is a long hold. Luna: Alright, Lucas. Good conversation. We'll keep watching the numbers — and the gap between them.