Prices Fell in November . . . or did they? Why PCE is so different than CPI.

The latest release of the Personal Consumption Expenditures (PCE) index presents a nuanced picture of the current state of inflation in the U.S. as of November 2023. The PCE index, the preferred indicator of the Federal Reserve, indicated a slight decrease in prices, falling by 0.1% in November, marking the first drop since April 2020. This decline brought the annual rate of inflation for the PCE to 2.6%, aligning with or falling below the Federal Reserve's projections for the fourth quarter. Conversely, core PCE, which excludes volatile food and energy prices to provide a more stable measure of inflation, showed a marginal increase of 0.1% for the month. However, the six-month annualized change for the core index registered at 1.9%, demonstrating a near-term trend that is slightly below the Fed's target of 2%.

In comparison, the Consumer Price Index (CPI) - released by the Labor Department - has not fallen as rapidly. The CPI in November 2023 was 3.12% higher than a year ago, suggesting a slower pace of decline in consumer prices as measured by this index. What gives?

The divergence between the PCE and CPI indices can be attributed to their different methodologies and the range of goods and services they encompass. The CPI primarily measures out-of-pocket expenses for urban consumers and gives significant weight to housing costs. In contrast, the PCE index captures a broader basket of goods and services, including those in rural areas and prices paid by non-profit organizations, government programs, and employer-sponsored healthcare plans, giving more weight to healthcare expenses and less to housing. Additionally, the PCE index adjusts more dynamically for changes in consumer behavior and spending patterns, a feature that often results in it showing slightly less inflation than the CPI.

While both the PCE and CPI indices show signs of inflation easing, different methodologies and scope result in differing perspectives on the pace and nature of this decline. The PCE, preferred by the Federal Reserve due to its broader scope and dynamic adjustments, suggests a more rapid alignment towards the Fed's inflation target while the CPI indicates a slower pace of easing in consumer prices. This divergence highlights the complexities inherent in measuring and interpreting inflation trends, particularly in a post-pandemic economic landscape.

It’s worth noting that, while the media’s headline regarding falling prices seems compelling, exciting, and even welcomed by many, economists are generally in agreement that the best policy is a small amount of inflation. Reason? Imagine if consumers expected prices to fall indefinitely. In such a scenario, they might postpone spending in anticipation of better deals tomorrow. This delay in consumption, excluding absolute necessities, could drastically slow economic activity. Given that consumer activity constitutes approximately 70% of GDP, a significant reduction in spending could severely impact the economy. For those reminiscing the days pre-Covid, if it’s up to the Fed, prices will never be the same.