CPI and PCE: two measures of inflation, and how to trade them
CPI is the inflation number everyone knows; PCE is the one the Fed actually uses. How they differ, why a hotter or softer print moves rates, the dollar and stocks, and the three scenarios I set out against the July 2022 expectations.
The idea
The consumer price index (CPI) is the best-known inflation indicator in the United States. It measures the average prices consumers pay for a common basket of goods and services, and it serves as a barometer of economic health.
However, when the Fed examines economic conditions to decide what it will do to influence inflation and employment, it sets aside the century-old measure in favour of the personal consumption expenditures price index (PCE).
PCE takes in a broader range of expenditures than CPI. It is weighted using data from business surveys rather than the less reliable consumer surveys that were previously used to weight the CPI. It also uses a formula that accounts for short-term changes in consumer behaviour, which the standard CPI does not.
Source: tradingeconomics.com
What's the difference?
PCE and CPI use different data sources, so the relative weights given to comparable items differ. In 2012 the PCE price index became the primary inflation index the US Federal Reserve uses when making monetary policy decisions.
PCE is published by the US Commerce Department's Bureau of Economic Analysis. It is derived from retail sales data collected in business surveys, and medical care is given the most weight. The CPI, by contrast, is derived from consumer purchases reported in household surveys. Consumers typically report spending more on shelter than on any other category, which gives shelter more weight in the CPI.
The CPI uses fixed weights from a basket of goods that is updated every two years. That doesn't account for new products coming in, or for price changes that lead consumers to substitute one item for another in the meantime.
How it moves the auction
Will the Fed raise rates by 50 or 75 basis points in late July? Where is the peak in interest rates: 3%, 3.5% or higher? The answers depend on whether inflation has already peaked in the US.
On yearly price rises, headline inflation at 8.6% is worrying, and it could get even worse. Economists expect a rise to 8.8% as energy prices kept advancing last month. The price at the pump is propelling prices towards double-digit rises.
A higher number means the Fed will have to go harder for longer to tame ramping inflation. Higher core inflation brings higher interest rates and a stronger dollar. Higher borrowing costs also make saving money more appealing and investing in risky stocks less appealing.
How to trade it
Against the July data expectations (source: Reuters), there are three scenarios.
- Data in line: if core CPI MoM comes in at 0.6 per cent, the dollar benefits and stocks suffer. It would show that price pressures remain elevated, and it would point to current market trends extending. Even a 0.5 per cent print, I would argue, would keep the dollar bid and stocks under pressure. That scenario would lock in a 75 basis point hike while leaving long-term interest rate expectations unchanged.
- Lower than expected: a 0.4 per cent rise would be an annualised 5%, less than the yearly figure, which would indicate inflation is dropping and the peak is behind us. The dollar would fall and stocks would rise. A 50 basis point hike in July, rather than 75, would become the favoured scenario. It would also fuel speculation that the Fed might settle for a terminal rate of less than 3%.
- Higher than expected: an unexpected rise of 0.7 per cent or more would be dire for equity valuations (remember, inflation is a value deflator for stocks) and would boost the dollar. Investors may even begin to think inflation is getting out of control and price in harder action from the Fed, with the terminal rate reaching +4 per cent. It would also fuel fears of a global recession and drive safe-haven flows into the dollar.
Pay close attention to the data and the market's reaction. By the end of the session that follows the release, the market's grading of inflation and of the Fed's future path will likely influence price action into the next Fed meeting.
Conclusion
Whether it's CPI or PCE, the markets are acutely focused on these numbers right now as they gauge the response to rampant global inflation caused by supply disruptions and Covid constraints. All of this against a backdrop of weakening economic activity and an attempt by the Fed to create a Volcker-style mini-recession and dampen demand.
One last thing: the White House has recently been harping on that this data is already out of date. The huge plunge in commodities has only recently happened and is unlikely to be reflected in the data (as of the July 2022 release).
This article will be updated from time to time to reflect the changing scene.
Key takeaways
See it in the journal
Real sessions where this happened, written up on the day.
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- CPI and PCE: two measures of inflation, and how to trade them
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