What's driving the gap between CPI and PCE inflation?
|Summary
Progress in reining in inflation is further along by some measures relative to others. The gap between the two most prominent measures of U.S. inflation—the Consumer Price Index (CPI) and PCE deflator—is unusually wide at present. At 3.8%, the year-over-year rate of core CPI sits a full percentage point higher than core PCE inflation compared to a historical gap of 0.3 points. In this report, we discuss key differences in the construction and use of CPI and PCE indices, the drivers of the current wedge and what it could mean for the path of interest rates ahead.
The CPI may be a more familiar measure of inflation than the PCE index given its long history and frequent use in price contracts. However, the FOMC benchmarks its 2% inflation target to the PCE deflator, making it more relevant for the path of monetary policy.
The CPI and PCE index move closely together over time but can temporarily diverge due to differences in construction. The CPI focuses on consumers' direct expenditures paid for out-of-pocket. That makes it narrower in scope than the PCE index, which includes the cost of items purchased on behalf of households and purchases furnished without payment. The wider scope of the PCE leads to different category weightings, most notably for healthcare and housing. Different formulas and sources also contribute to the variation in reported price growth.
On a categorical basis, housing has been by far the largest source of the inflation wedge the past year. While primary shelter inflation is up a little less than 6% by both the CPI and PCE index, it carries 2.5x the weight in the core CPI. As a result, primary shelter has contributed 1.5 percentage points more to the year-over-year rate of core CPI than core PCE. Motor vehicle insurance is also providing an unusually large boost to core CPI. In contrast, strength in services categories more heavily weighted in the core PCE index, such as healthcare, or out of scope of the core CPI, such as food services or nonprofit institutions, have helped to narrow the chasm between core CPI and core PCE the past year.
We anticipate the gap between core CPI and core PCE when measured on a year-ago basis to remain uncharacteristically wide through the first half of 2025. Bringing the gap back down to its historical realm of 0.3 points will hinge heavily on shelter inflation returning near its pre-pandemic pace, which we estimate will occur around next spring. Slower growth in the CPI measure of motor vehicle insurance now that premiums have increased more than vehicles and repair service costs should also help to bring core CPI down closer in line with core PCE.
We do not believe the inflation wedge is an issue for the FOMC. Fed officials continue to espouse optimism that shelter inflation, the most significant contributor at present, will ease further in the coming months. And although large, the current wedge between core CPI and core PCE is not unprecedented. A similarly sized wedge opened up in the late 1990s and in 2001 and 2009. As the pricing environment cools from its extreme state, the gap should diminish as well.
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