Latest / Inflation Explained with Fexingo: CPI, Prices, and the Cost of Living for Everyday People / Why the Fed Keeps Missing with Its Favorite Inflation Gauge
Transcript
- Lucas: So the Fed's preferred inflation gauge — Core PCE — came out a few days ago, April reading, three point three percent annualized. Right in line with expectations. And the market basically shrugged. Luna: Yeah, the S&P hit another all-time high this week, seven thousand five hundred eighty. But I keep wondering — why does the Fed use PCE at all when everyone talks about CPI? Lucas: Great question. And it's actually a weird institutional choice that has huge consequences. The Fed itself has said since 2000 that PCE is its primary inflation measure. But most people — including journalists — default to CPI. So there's this constant gap in perception. Lucas: Look, if walking through the economy with us has made something click — maybe you've started noticing these data gaps yourself — it's worth saying that this show stays ad-free because of listener support. If you find value in these conversations, you can help keep them going at buy me a coffee dot com slash fexingo. No pressure, just mentioning it. Luna: Yeah, it's a small thing that makes a big difference for us. So back to the pce cpi gap — what's actually different in the math? Lucas: Right. So there are two big mechanical differences. First, weights. CPI is based on a fixed basket of goods from a survey of urban consumers. PCE uses a much broader measure of what people actually buy — it's based on business receipts, so it captures things like employer-paid health insurance, which CPI mostly ignores. Luna: That's huge because medical costs have been rising faster than general inflation. So PCE would give more weight to that. Lucas: Exactly. And the second difference is substitution. CPI assumes people keep buying the same basket even if prices change. PCE assumes people switch to cheaper alternatives — like buying chicken instead of beef if beef spikes. That makes PCE naturally lower than CPI over time, because it accounts for how people actually adapt. Luna: So when the Fed says three point three percent, it's already lower than what most consumers feel. Which is why you get that 'inflation feels worse than the number' phenomenon we covered in episode six. Lucas: Precisely. And right now, with the Iran conflict pushing energy costs higher — we saw that headline about the average household paying four hundred fifty dollars more on gas — PCE's energy component is actually less volatile than CPI's. Because PCE smooths gas prices over a longer consumption period. Luna: So the Fed might be looking at a number that deliberately filters out some of the pain people are actually feeling at the pump. Lucas: That's the tension. Fed Governor Goolsbee said this week that energy inflation has been 'more persistent than expected.' But the core PCE number strips out food and energy entirely. So the Fed is setting policy based on a gauge that ignores the very shock it's worried about. Luna: And Kashkari said the inflation fight takes priority because the labor market is 'in decent shape.' But if the labor market is decent, why not hike rates to crush the energy pass-through? Lucas: Because the Fed funds rate is at three point six two percent, and the committee is split. Some members think the economy is slowing enough on its own — the housing market is definitely cooling. Others, like Kashkari, want to stay tight. But using PCE as the guide gives them cover to wait, because PCE looks less alarming than CPI. Luna: So is PCE the wrong gauge? Or is the Fed using it as a convenient excuse to avoid more hikes? Lucas: I think it's a bit of both. PCE is technically a better measure of the economy-wide price level — it's more comprehensive. But it's a worse measure of what households actually experience. And the Fed's dual mandate is maximum employment and stable prices. If prices feel unstable to voters, the Fed has a credibility problem, even if the PCE number looks fine. Luna: Right. And we saw this in the 1970s — the Fed kept looking at one set of numbers while inflation was already embedded in expectations. By the time they acted, it was too late. Lucas: Exactly. So the question is: are we repeating that pattern? Core PCE at three point three sounds manageable. But add energy, add shelter, add insurance — which we've talked about in past episodes — and the real-world inflation rate is probably north of five percent. Luna: So what would it take for the Fed to switch to a different gauge? Or at least supplement PCE with something that captures the lived experience? Lucas: That's a fascinating institutional question. The Fed has been using PCE since 2000, and changing would be a massive communication challenge. They'd have to re-anchor expectations around a new number. But some economists, like former Fed Governor Laurence Meyer, have argued for a 'trimmed mean' PCE that cuts out the most extreme price changes month to month. Luna: That sounds like a compromise. But does it solve the substitution bias? Lucas: Not really. The trimmed mean is about volatility, not substitution. The Dallas Fed actually publishes a trimmed mean PCE, and it's been running around three percent lately — a bit lower than the headline core. So it's not a magic bullet. Luna: I want to zoom out for a second. The PCE data comes from the Bureau of Economic Analysis, right? Based on business surveys. CPI is from the Bureau of Labor Statistics, based on household surveys. So we're basically comparing two different pictures of the economy: what businesses sell vs. what households buy. Lucas: That's exactly right. And the gap between them has been widening. Over the past year, CPI has averaged about 0.7 percentage points higher than PCE. That's actually a bit wider than the historical norm of about 0.4 to 0.5. So the discrepancy is growing. Luna: And that means the Fed is effectively using a rosier picture than what most people experience. Which feeds into the 'double scar' narrative from that CNBC headline — people are still scarred by the 2021-2022 inflation spike, and now they see high prices persisting, but the official numbers say it's moderating. Lucas: That's the double scar. And it's a real risk for the Fed. If they declare victory too early based on PCE, but households are still feeling the pinch, you get a disconnect that erodes trust in the central bank. We saw that play out in the UK with the Bank of England last year. Luna: So for our listeners who are watching their budgets right now — what's the one thing they should take away from this episode? Lucas: I'd say: know which number the Fed is watching, but don't let it gaslight you. If your rent is up 8 percent and your grocery bill is up 6, don't let a three point three percent PCE reading make you feel like you're imagining things. The official data is real, but it's also a construction — it's built on assumptions. And the assumption that people seamlessly substitute cheaper goods doesn't always hold when you're actually at the store. Luna: Yeah. And it's especially tough when the things you can't substitute — like rent, insurance, medical care — are the ones rising fastest. Those are the categories where CPI actually does a better job capturing out-of-pocket costs, because it surveys households directly. Lucas: Right. So the irony is that for the things that hurt most, CPI is more accurate. But for the broad economy, PCE is more comprehensive. The Fed has chosen comprehensive over painful. And that's a policy choice with real consequences. Luna: So if you're the Fed, do you start publishing a 'household inflation gauge' alongside PCE? Something like what the Cleveland Fed has done with their Inflation Expectations series? Lucas: I think they should. And some staffers have floated it internally. But the FOMC is a conservative institution. They don't like adding new metrics until there's a crisis. The question is whether we're already in one — or just on the edge. Luna: Alright, I think we'll leave that as a question for the next FOMC meeting. Lucas, thanks for unpacking the PCE riddle. Lucas: Always a pleasure. This is Inflation Explained with Fexingo — we'll see you next time.