PCE and Deflators: How PCE Differs from CPI and Why the Fed Targets It

What you will learn

• The three sources of difference between the PCE price index and the CPI: formula, weights and scope.
• Why the Federal Reserve targets PCE and how the market pre-computes it from CPI and PPI data.
• What the GDP deflator measures and how to back it out from nominal and real growth.
• How to read a PCE release alongside personal income and spending.

Explanation

What PCE is. The Personal Consumption Expenditures (PCE) price index is published by the Bureau of Economic Analysis (BEA) in the monthly Personal Income and Outlays report, about two weeks after the CPI for the same month. It is the price index of the consumption part of GDP. The Federal Reserve switched its preferred measure from CPI to PCE in 2000 and since 2012 has stated its goal as 2 percent PCE inflation; it also watches core PCE and the Dallas Fed's trimmed-mean PCE.

Three differences from CPI.

• Formula effect. The CPI is a Laspeyres-type index with weights fixed for a year, so it misses consumers switching to cheaper substitutes within the year. PCE uses a chained Fisher formula with monthly weights, which captures substitution and tends to make PCE inflation a little lower over time.
• Weight effect. CPI weights come from household surveys of out-of-pocket spending; PCE weights from business sales data in the national accounts. Housing is about a third of CPI but roughly half that share of PCE. Health care is far larger in PCE, because PCE counts spending made on households' behalf by employers and government insurance, which the CPI leaves out.
• Scope effect. PCE covers spending by and for households, including non-profits serving households and imputed items such as free financial services. CPI covers only urban households' direct purchases.

Hot shelter inflation therefore lifts CPI more than PCE; rising medical costs lift PCE more. Most PCE components come from the CPI and the rest (airfares, medical services, portfolio management) from the Producer Price Index (PPI). Once CPI and PPI are out, economists forecast core PCE to one decimal, so the PCE release is rarely a large surprise; the news is usually in revisions, real spending and income.

Deflators. A deflator is an implicit price index obtained by dividing a nominal value by its real (inflation-adjusted) value: deflator = nominal / real × 100. The GDP deflator covers the prices of everything produced domestically, including investment goods, government purchases and exports, but not imports, so it moves with export and oil prices in ways consumer inflation does not. The PCE price index is, in effect, the deflator of the consumption component. Destatis publishes a German GDP deflator with the detailed quarterly accounts, but it is late and heavily revised, so the HICP remains the ECB's guide.

Reading the release. Three lines matter most: core PCE m/m to two decimals (calculated from the index levels), real personal spending and the saving rate. Nominal spending up with real spending flat means prices, not volumes, did the work.

Worked example

Hypothetical example, part 1: the same component price changes with CPI-style and PCE-style weights. Round numbers, invented for illustration.

CPI-style rate: 0.35 × 4.0 + 0.07 × 2.0 + 0.58 × 1.5 = 1.40 + 0.14 + 0.87 = 2.41 percent.

PCE-style rate: 0.16 × 4.0 + 0.17 × 2.0 + 0.67 × 1.5 = 0.64 + 0.34 + 1.005 = 1.99 percent.

Identical price movements, a gap of 0.4 points caused entirely by weights. When housing inflation is high this "wedge" widens; when housing cools it narrows.

Part 2, the deflator: nominal GDP grows 5.0 percent and real GDP 2.0 percent. Implied deflator growth is 1.05 / 1.02 − 1 = 2.94 percent, not 3.0 percent; simple subtraction is a fair approximation only when rates are small.

Common mistake

Practice activity

On paper: (a) nominal consumer spending rises 0.5 percent in a month and the PCE price index 0.3 percent; what is real spending growth? (b) Using the table above, how much does the CPI–PCE wedge change if housing inflation falls from 4.0 to 2.0 percent, other components unchanged? (c) Nominal GDP grows 1.2 percent q/q and the deflator rises 0.7 percent; what is real growth?

Key takeaways

• PCE differs from CPI through formula (chained Fisher), weights (less housing, more health care) and scope (spending on behalf of households).
• The Fed's 2 percent goal refers to PCE; the market forecasts core PCE closely from CPI and PPI, so PCE day is rarely a big surprise.
• A deflator is nominal divided by real; the GDP deflator covers all domestic output, not just consumption.
• Track the CPI–PCE wedge: it widens when housing inflation is high and narrows when it cools.

Next step

Next we turn from prices to people: the US labour reports, their two surveys and the revisions that make the headline payroll number so hard to read.