Latest / Inflation Explained with Fexingo: CPI, Prices, and the Cost of Living for Everyday People / The Fed's Preferred Inflation Gauge and Your Wallet
Transcript
- Lucas: So the Fed's preferred inflation gauge came out this week — the PCE price index — and core prices are up three point three percent annually. That's not the CPI number you usually hear about, but it's the one that actually drives interest rate decisions. Luna: Remind me again why the Fed cares more about PCE than CPI? Isn't CPI the one that gets all the headlines? Lucas: Right, CPI is the headline grabber. But the Fed has used PCE as its primary inflation measure since about 2000. And there are a few reasons. First, PCE covers a broader swath of the economy — it includes spending on behalf of households, like employer-paid health insurance and Medicare. It also weights items based on what people actually buy, and it updates those weights more frequently. So if people suddenly start buying more chicken and less beef, PCE catches that shift faster than CPI. Luna: So it's basically a more dynamic, real-world measure. But does that make it better, or just different? Lucas: Most economists would say better for the Fed's purposes. Because it reflects substitution — when prices spike, people adjust their spending, and PCE accounts for that. CPI assumes a fixed basket, so it tends to overstate inflation a bit. In fact, PCE has historically run about a quarter to half a percent lower than CPI. And when you're setting rates that affect the entire economy, you want the most accurate picture possible. Luna: Okay, so the Fed watches PCE. But what does that actually mean for us? Like, my grocery bill doesn't care which index the Fed prefers. Lucas: Sure, but the Fed's rate decisions trickle down to your borrowing costs. When core PCE is running hot, the Fed tends to keep rates higher or even hike. And right now, core PCE is at three point three percent, which is above the Fed's two percent target. So that's a signal that rates might stay elevated — or even go up. Remember, the effective fed funds rate is sitting at three point six three percent, and some Fed officials are already talking about acting. Luna: Like Hammack saying 'now is the time to act' on rate hikes. That was this week, right? Lucas: Exactly. Cleveland Fed President Beth Hammack said that. And the new Fed chair, Kevin Warsh, has expressed concern about inflation and even suggested the Fed should be quieter in its communications. So the tone from the top is hawkish. If PCE stays sticky, we could see a rate hike by the fall. Luna: But hold on — CPI came in at three hundred thirty-two point eight in July, which is still above two percent, but it's been cooling. Why does the Fed seem more worried about PCE? Lucas: Because PCE is actually running hotter than CPI right now, which is unusual. Core PCE rose to three point three percent annually, while core CPI is around three point two. That's a flip from the historical pattern. And that's partly because of what's included — PCE has a bigger weight on things like healthcare and financial services, which have been rising faster. So the Fed's preferred gauge is telling them inflation isn't cooling as fast as CPI suggests. Luna: That's a really important nuance. So when we hear 'inflation is cooling,' we should ask which measure they're talking about. Lucas: Exactly. And that's the practical takeaway. If you're planning a big purchase or refinancing, you want to know what the Fed is actually looking at. If PCE stays above three percent, mortgage rates could stay high — or even climb. The ten-year Treasury is already near four and a half percent, which keeps upward pressure on borrowing costs. Luna: And that affects everything from auto loans to credit card rates. It's not just about the stock market. Lucas: Right. And the stock market is at record highs — the S&P 500 hit seventy-seven hundred and twelve this week. So investors are betting on a soft landing. But the bond market is sending a different signal. Ten-year breakeven inflation — that's the market's expectation for future inflation — fell to two point three one percent. That suggests traders think inflation will ease. But the Fed's own gauge says otherwise. Luna: So there's a disconnect between what the bond market expects and what the Fed is seeing. Lucas: Yeah, and that's a classic source of market volatility. When the Fed acts against expectations, that's when you see big swings. So for anyone with a portfolio or a big purchase ahead, keeping an eye on PCE is smart. It's like having a window into the Fed's next move. Luna: That's actually a really helpful way to think about it. So, if PCE is the Fed's window, what's in the window right now? Just the core number, or are there other details? Lucas: Good question. The monthly change matters too. Core PCE rose from one hundred thirty point three four to one hundred thirty point seven in July. That's a point three percent monthly increase, which is a bit faster than the previous month. So the trend is not your friend if you want lower rates. And the Fed also watches the breadth of inflation — how many categories are rising above two percent. That's still pretty broad. Luna: So it's not just about the headline number. It's about the composition and the momentum. Lucas: Exactly. And that's why we do this show — to cut through the jargon and make it applicable to your life. Speaking of which, if navigating the economy with us has made something click, you can support the show by buying us a coffee at buy me a coffee dot com slash fexingo. Every little bit helps keep us ad-free and independent. Luna: Yeah, we really appreciate the people who chip in. It lets us keep digging into the numbers without any corporate strings attached. Lucas: So, back to PCE — one thing that often gets overlooked is how the Fed's preferred measure affects your paycheck. Some economists argue that PCE should be used to index Social Security and other benefits, because it better reflects actual spending patterns. Luna: But wouldn't that mean smaller cost of living adjustments for retirees? Because PCE usually runs lower than CPI. Lucas: Right, that's the trade-off. In the past, PCE has run lower, so switching would mean smaller increases for Social Security recipients. But right now, PCE is actually running higher, so it would mean bigger checks. That's unusual, and it highlights how much these technical choices matter. Luna: Wow, so the Fed's choice of index could have a direct impact on millions of retirees' monthly income. Lucas: Exactly. And it's not just about the Fed — the government uses CPI for benefits, but if they ever switched to PCE, it would be a big deal. This is one of those wonky debates that actually hits your wallet. Luna: So, for a regular person, what's the one takeaway from this episode? Lucas: I'd say: don't just watch CPI. Watch PCE, because that's what the Fed is watching. And when core PCE is above three percent, expect rates to stay high — or go higher. That means your borrowing costs aren't going down anytime soon. Plan accordingly. Luna: That's solid advice. And thanks for breaking it down so clearly. This is one of those topics that seems intimidating but is really just about knowing where to look. Lucas: Exactly. And we'll keep watching the data so you don't have to. Until next time, keep an eye on that core PCE.