The unusually wide gap between the two main US inflation gauges is poised to narrow in the months ahead, giving Federal Reserve officials more cover to pause interest-rate increases in early 2023.
Over the last several months, annual inflation as measured by the consumer price index has exceeded that of the personal consumption expenditures price gauge by the most since the early 1980s. Excluding food and energy, the difference in so-called core inflation is also the widest in decades.
Data out Thursday are forecast to show the core PCE price index, which the Fed counts as a preferred inflation gauge, decelerated in October to 5% from a year earlier. Core CPI, which came out earlier this month, cooled to 6.3%.
But some of the measurement quirks that have put more distance between the two metrics are set to fade in the coming months, while others are set to kick in and contribute to a narrowing. That will help inflation ease toward the central bank’s 2% target. Economists generally expect the core gauges to settle back into a 3-3.5% range by the end of 2023.
“The convergence is going to be important for Fed policy next year and driving the discussion” because “you’re going to get less of those red flags coming from the CPI report,” said Jeremy Schwartz, senior US economist at Credit Suisse.
“Because CPI is sending the strongest hawkish message right now, it will count extra that it’s slowing down, and catching down to PCE,” he said.
Here are a few of the most important things to watch in coming inflation reports to track progress as the gap closes:
The Differences
Conceptually the two gauges measure different things.
The CPI aims to capture out-of-pocket spending by Americans, leading to notable weightings for things like rent and cars. But the PCE tries to measure the costs of everything we consume, whether households directly foot the bill or not. The result is big differences in the weightings of categories, and in which costs are included in the measure.
This is most notable in regard to health care. Unlike the CPI, the PCE includes all health care spending, including by employers on behalf of workers as well as taxpayer-funded programs like Medicare.
As a result, health care makes up nearly a fifth of the core PCE gauge but only around 11% of the core CPI, said Omair Sharif, founder of Inflation Insights LLC.
When taking into account methodology differences, medical care is on track to help bring down the CPI over the next year while the same category is seen as adding to the PCE gauge.
As of the latest CPI report, the health insurance index has already started pulling down core inflation, a reflection of an annual update to the source data. That helps explain a 0.6% monthly decline in the broader medical care services category.