Latest / Inflation Explained with Fexingo: CPI, Prices, and the Cost of Living for Everyday People / How the Fed's Favorite Inflation Gauge Now Reads 3.4 Percent
Transcript
- Lucas: So the core PCE price index — the Fed's preferred inflation gauge — hit 3.4 percent in May. That is the highest reading since October 2023. Luna: And this is the one the Fed actually targets, right? Not the CPI we hear about every month. Lucas: Exactly. The Fed's target is 2 percent for core PCE. We are at 3.4. That is a full 1.4 percentage points above target. And the number has been creeping up — it was 3.3 in April, 3.2 in March. The trend is not our friend. Luna: So what changed in May? Was it one big category or broad-based pressure? Lucas: Broad-based, but services were the main driver. Services inflation in the PCE — things like healthcare, financial services, housing — those run hot. Goods inflation has actually been pretty tame, even negative in some categories like used cars. But services are sticky. Luna: We've talked about that on the show before — services inflation is the last to cool. But remind me why PCE and CPI can diverge so much. Lucas: Great question. There are a few key differences. First, the weights: CPI weights are based on a fixed basket of goods from a survey of urban consumers. PCE uses a much broader measure of what households actually spend — it includes things like employer-paid health insurance, which CPI doesn't. Second, PCE can adjust for substitution — if beef gets expensive and people buy chicken, PCE captures that shift. CPI doesn't adjust as quickly. Luna: So theoretically PCE should be more accurate, but it's also been running higher than CPI lately. That's unusual, right? Lucas: Historically, PCE tends to run about 0.3 to 0.4 percentage points below CPI. But since late 2024, the gap has narrowed and sometimes flipped. In May, core CPI was 3.5 percent — only a tenth higher than core PCE. The gap is almost zero. That tells you the inflation problem is real across both measures. Luna: And this is the number the Fed's decisions are based on. So with core PCE at 3.4 percent, what does that mean for rate cuts? Lucas: It pushes them further out. The fed funds rate is currently at 3.63 percent — that's effectively flat since the last cut in April. The market had been pricing in a possible cut in September. But after this print, September looks optimistic. I think we're looking at December at the earliest, maybe even 2027. Luna: But the economy is clearly slowing — the manufacturing PMI has been below 50 for months, job growth is decelerating. At what point does the Fed prioritize employment over inflation? Lucas: That's the classic dual mandate tension. Right now, the labor market is still relatively solid — unemployment is around 4.1 percent. The Fed has said they need to see 'greater confidence' that inflation is moving sustainably toward 2 percent before cutting. A 3.4 percent core PCE does not give them that confidence. Luna: So we're stuck in this holding pattern — rates high, inflation sticky, economy cooling but not crashing. Lucas: Exactly. And the risk is that if they wait too long, they could tip the economy into recession. But if they cut too soon, inflation could reaccelerate. It's a narrow path. Luna: Let's talk about what's actually driving that services stickiness. What are the biggest contributors to core PCE right now? Lucas: Housing is the biggest single component — about a third of core PCE. Rent and owners' equivalent rent are still rising at around 5 percent annually. Then you have healthcare services, which have been accelerating — partly due to higher labor costs for nurses and aides. Financial services and insurance are also up sharply. Car insurance alone is up over 20 percent year-over-year. Luna: And those are the categories that are least sensitive to interest rates. Cutting rates won't lower your car insurance premium. Lucas: Right. That's the challenge — the inflation we have now is not demand-pull in the classic sense. It's cost-push, it's structural, it's tied to labor shortages and supply chain adjustments. Monetary policy is a blunt tool for that. Luna: So if the Fed can't do much about it, what's the realistic path to 2 percent? Do we just have to wait for these categories to normalize on their own? Lucas: In large part, yes. But there are some hopeful signs. The 10-year breakeven inflation rate — that's the market's expectation for average inflation over the next decade — is at 2.2 percent, down from 2.21 last week. That suggests investors don't expect this stickiness to last forever. Also, goods prices are deflating in some areas, which helps offset services. Luna: But 2.2 percent is still above the Fed's 2 percent target. And breakevens have been wrong before. Lucas: Absolutely. But it's a useful sanity check. The bond market is saying inflation will drift down slowly, not spike. That at least keeps the Fed from having to hike rates again, which would be a real shock. Luna: Speaking of shocks — any chance the Strait of Hormuz situation reignites energy inflation and messes with these numbers? Lucas: It's a wildcard. Shipping has rebounded a bit after the U.S.-Iran deal, but there was another attack on a vessel last week. If that escalates, oil prices could spike, and that would feed into headline PCE quickly. But core PCE excludes food and energy, so it would be less directly affected. Still, higher energy costs ripple through transportation and manufacturing, so it could eventually hit core. Luna: So to sum up: core PCE at 3.4 percent, highest since late 2023, rate cuts unlikely before December, services inflation remains stubborn, and geopolitical risks linger. Lucas: That's the picture. And if you're someone who finds these economic connections useful — if walking through the data with us has helped you make sense of your own finances or investments — there's a simple way to support the show. A couple of dollars a month genuinely keeps these episodes coming. You can head to buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small gesture that makes a real difference for us. We keep the show ad-free and focused on the numbers that matter because of listeners like you. Lucas: Exactly. So back to that PCE print — one more thing worth noting. The May data also showed personal income rose 0.4 percent, and consumer spending rose 0.3 percent. Spending is slowing, which is consistent with the idea that higher rates are starting to bite. But it's not collapsing. Luna: So the consumer is still hanging on, just more cautiously. Lucas: Exactly. And that's the kind of slow cooling the Fed wants to see — not a sudden stop, but a gradual easing of demand that allows inflation to drift lower without triggering mass layoffs. The question is whether that gradual path gets derailed by something external. Luna: Like a geopolitical shock or a sudden jump in unemployment. Lucas: Right. So we'll be watching the June PCE data closely — that comes out in late July. If it comes in at 3.3 or lower, that's a step in the right direction. If it ticks up again, then the Fed's patience starts to look more like paralysis. Luna: And we'll be here to break it all down. Thanks for listening, everyone. Lucas: Until next time.