PCE vs CPI: Why Does the Fed Prefer the PCE? How Are the Two Inflation Metrics Different?

With inflation continuing to weigh on the U.S. economy, investors and analysts have been paying particular attention to the two monthly inflation data reports: the Personal Consumption Expenditures (PCE) Price Index and the Consumer Price Index (CPI). While both measure the change in prices each month, they do so in unique ways that affect their end results.

PCE vs. CPI: What’s the Difference?

Well, there are actually many divergences between the two inflation measures. At a very basic level, the CPI is constructed by the Bureau of Labor Statistics (BLS), while the PCE is made by the Bureau of Economic Analysis (BEA).

Generally, the CPI releases several weeks earlier than the PCE each month, while the PCE is considered slightly more accurate than its counterpart.

Interestingly, the CPI also usually shows higher inflation than the PCE. In fact, since 2000, annual PCE-measured inflation has been about 0.4% lower than CPI-measured inflation, although the gap between the two has shrunk in recent years.

However, the main distinction between the two lies in how they measure inflation. This can be broken down into three primary effects on their respective inflation calculations.

1. Formula Effects

The CPI and PCE are constructed using unique index formulas. The CPI relies on a Laspeyres formula, whereas the PCE uses a Fisher-Ideal Formula. The PCE’s Fisher-Ideal formula is considered more accurate as it accounts for consumer substitution of goods as relative prices change. For example, as the price of milk goes up, people frequently purchase less milk, which the PCE takes into account. However, the PCE formula depends on more current data, which explains why the PCE releases later than the CPI each month.

2. Weighting Effects

Each index also maintains different weightings for its categories of items. The CPI’s weights are based on the Consumer Expenditure Survey conducted by the Bureau of Labor Services (BLS). While the PCE’s weights are based on spending data, like the Census Bureau’s retail trade surveys. As a result, each inflation metric weighs some things slightly differently than the other. Famously, housing makes up 33% of the CPI but just 15% of the PCE basket.

3. Scope Effects

The two indices use different scopes for measuring consumption. The CPI gauges purchases made by all urban households, while the PCE uses changes in goods and services consumed by all households, as well as nonprofit institutions serving households. As a result, some expenditures counted in the PCE are outside the CPI’s scope. This contributes to the general opinion that the PCE is more inclusive and accurate than the CPI.

Other minor nuances exist between the PCE and CPI inflation calculations, including differences in seasonal adjustments, pricing differences and miscellaneous differences.

PCE Vs. CPI: Why Does the Fed Prefer the PCE?

Since 2000, the Federal Reserve has championed the PCE report as its inflation gauge of choice. Not for nothing, the PCE has some clear benefits over the CPI report.

As mentioned, the PCE has greater scope, more accurate weighting methods, and uses a more precise formula than the CPI. To that end, economists generally value the PCE as the superior inflation gauge.

However, frequently, it’s the CPI that moves markets.

That’s because even though the CPI and PCE tend to follow the same general trajectory, traders are more likely to respond erratically to a surprise CPI reading than the follow-up PCE equivalent, as they’ve already priced in the expected inflation movement. This typically reduces the shock factor of the PCE and dulls market movement stemming from it later in the month.

The PCE and CPI each report both “headline” and “core” inflation. Core inflation excludes the volatile Food and Energy categories. While core inflation is useful for picking up on trends in prices, in real life, people buy food and energy. Hence why headline inflation better describes changes in peoples’ day-to-day expenses.

On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

With degrees in economics and journalism, Shrey Dua leverages his ample experience in media and reporting to contribute well-informed articles covering everything from financial regulation and the electric vehicle industry to the housing market and monetary policy. Shrey’s articles have featured in the likes of Morning Brew, Real Clear Markets, the Downline Podcast, and more.