[News Terms] What Is PCE Inflation Loved by the US Fed and How Does It Differ from CPI?

US October PCE Price Index Up 6%... Inflation Rise Slows
Biden: "Early Signs of Inflation Resolution"

On the 2nd of last month (local time), Jerome Powell, Chairman of the U.S. Federal Reserve (Fed), held a press conference in Washington DC, USA. [Image source=Yonhap News]

[Asia Economy Reporter Heo Midam] The inflation rate announced in the United States is showing signs of slowing down, raising expectations that the U.S. Federal Reserve (Fed) will adjust the pace of tightening.

The U.S. Department of Commerce announced on the 1st (local time) that the Personal Consumption Expenditures (PCE) price index for October rose 6.0% compared to the same month last year, indicating a slight slowdown in the upward trend. The PCE price index is the inflation indicator preferred by the Fed, and it is analyzed that the Fed's aggressive interest rate hikes have contributed to easing inflation. U.S. President Joe Biden also evaluated the slowdown in the PCE rise as a sign of easing inflation.

Earlier, the U.S. Department of Labor announced that the Consumer Price Index (CPI) for October rose 7.7% compared to the same period last year, marking the smallest increase in nine months. On the 2nd, Statistics Korea announced that the November Consumer Price Index recorded 5.0%, which is also the lowest inflation rate since April (4.8%).

Inflation situations are generally understood through the Consumer Price Index (CPI) announced by each country. In Korea, it is compiled and announced by Statistics Korea, while in the U.S., it is done by the Department of Labor. However, the U.S. Department of Commerce also separately announces the PCE (Personal Consumption Expenditure) price index.

What are CPI and PCE... Differences in Scope and Calculation Methods

The commonly known inflation indicator is the CPI, but the Fed prefers the PCE when monitoring inflation trends. Until 1999, the Fed used the core CPI, but in 2000, it switched to the core PCE as the reference inflation index. Why does the Fed particularly prefer the PCE?

First, the PCE has the advantage of covering a broader range of items for price assessment. While the CPI is calculated mainly based on household direct expenditures, the PCE includes both direct and indirect household expenditures. Goods and services purchased by the government on behalf of households are also reflected in the PCE. For example, costs provided to households through government healthcare programs are not included in the CPI but are reflected in the PCE. Ultimately, the PCE has a broader scope.

Additionally, the PCE updates the weights of items more frequently than the CPI, thus more promptly reflecting changes in consumption patterns. The U.S. government adjusts the items and services composing the CPI every two years, whereas the PCE's composition is adjusted quarterly.

There are also differences in calculation methods. The CPI includes only goods and services directly purchased by urban consumers, while the PCE covers all households across the United States. Moreover, the PCE accounts for substitution effects when the price of a specific item rises, considering the decrease in demand for that item.

For example, if the price of cola rises, the PCE significantly reflects the increased demand for its substitute, cider. Therefore, even if the two indicators show similar trends, the PCE is considered to reflect inflation more accurately than the CPI in the long term.

In the U.S., the CPI is calculated by the Bureau of Labor Statistics (BLS) under the Department of Labor using the Laspeyres formula, which weights prices of individual goods and services by their consumption shares in the base year. The PCE is calculated by the Bureau of Economic Analysis (BEA) under the Department of Commerce using the Chain-weight Fisher formula, which is a geometric average of the Laspeyres and Paasche formulas.

The Inflation Indicator Preferred by the Fed is 'Core PCE'

The inflation index that the Fed particularly emphasizes is the 'Core PCE.' This is the indicator that Fed Chair Jerome Powell has stated is effective for judging inflation trends.

The Core PCE is a measure with less volatility than the PCE, excluding food and energy prices, which tend to fluctuate more. Food and energy prices are often determined by external factors both domestically and internationally, so they are excluded. An example is the significant rise in oil prices due to Russia's invasion of Ukraine.

Meanwhile, Chair Powell mentioned that the Fed could slow the pace of interest rate hikes as early as the December meeting. In a speech hosted by the Brookings Institution on the 30th of last month, he said, "The time to ease the pace of rate hikes could come as early as December."

However, Chair Powell emphasized, "Despite some progress, there is still a long way to go to restore price stability," and "It will be necessary to maintain restrictive policy levels for some time to achieve price stability."