The Fed’s preferred metric enables it to make crucial decisions that affect price stability and maximizing employment.
Almost every week, we encounter a slew of US economic data in the news which are all equally important in determining the policy rate path of the US Federal Reserve. In particular, the core Price Consumption Expenditures (PCE) price index is one of the most anticipated data release every month both by the central bank and the markets. It is the Fed’s preferred inflation metric to monitor price increases since it provides a complete picture of the cost of living for households. But how does this prove to be an effective measure for monetary policy decisions? Let us take a look.
What is the core PCE price index?
The core Price Consumption Expenditures (PCE) Price Index, also known as the core PCE price index, is released as part of the monthly Personal Income and Outlays report by the Bureau of Economic Analysis (BEA) in the United States.
The PCE price index, in general, is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. According to BEA, the PCE price index is known for capturing inflation or deflation across a wide range of consumer expenses and reflecting changes in consumer behavior. For example, if the price of beef rises, then consumers may buy less beef and more chicken.
The “core” measurement PCE price index is the less volatile measure of the PCE price index which excludes the more volatile and seasonal food and energy prices. Food and energy are staples in our day to day lives. Our demand for them do not change much even prices rise. Gas prices may rise with the price of oil, but you will still need to fill up your gas tank to drive your car. Similarly, a consumer will not skip his weekly grocery run just because prices are rising at the store.
What is the significance of the core PCE price index?
Like most central banks around the world, the Fed also seeks to stabilize overall consumer prices. The Fed vows to communicate their long term inflation goal of 2% clearly to the public to help keep longer-term inflation expectations firmly anchored, thereby fostering price stability. Thus while food and energy make up an important part of the budget for most households, core inflation measures that leave out items with volatile prices can be useful in assessing long term inflation trends.
What is the difference between the Consumer Price Index (CPI) vs the PCE Expenditures Price Index (PCE)?
We should not, however, confuse the Consumer Price Index (CPI) and PCE price index. A key difference of these two inflation metrics is how the data are sourced. For example, the CPI only tracks out-of-pocket consumer medical expenditures, while PCE also tracks expenditures made for consumers like employer contributions. Price data for the PCE index comes from surveys of businesses, rather than what consumers say they are spending on goods and services.
The CPI also does not account for substitution costs paid by others that consumers benefit from. As mentioned earlier, the PCE’s basket of goods and services changes regularly to account for substitution – when prices for one item rise, consumers shift their spending to cheaper alternatives.
This is why PCE or more specifically the core PCE, play an important role in the US economy. In January 2012, the Federal Open Market Committee (FOMC) adopted the PCE as its primary measure of inflation over CPI. The PCE adjusts its basket weights as people substitute more expensive goods and services for less expensive ones, and the PCE includes a more comprehensive coverage of goods and services.