The recent rise in the personal consumption expenditures index could make the Federal Reserve more reluctant to cut interest rates. By Elijah Nicholson-Messmer

Kevin Warsh, President Donald Trump's nominee for Federal Reserve chair, faced pointed questions Tuesday at his Senate Banking Committee confirmation hearing, with lawmakers zeroing in on his lack of investment disclosures, his stance on Fed independence and, of course, inflation.

While the public looks to the consumer price index, or CPI, to track inflation, the Fed spends its time watching a different set of initials: PCE.

The personal consumption expenditures price index, a monthly measure of the prices Americans pay for goods and services, is the Fed's preferred gauge of inflation and a key input in its interest-rate decisions.

Damjan Pfajfar, vice president in the research department at the Federal Reserve Bank of Cleveland, says the central bank prefers the PCE because it provides a "broader measure of inflation." Speaking with Barron's on April 17, he said the PCE is a "more accurate reflection of what consumers are actually spending."

Compared with the CPI, which only includes urban consumers, the PCE also measures rural households and spending done on behalf of consumers, including employer-provided health insurance, Medicare, and Medicaid. With monthly updating of its weightings -- the relative importance of different sectors -- the index also better reflects shifts in consumer behavior, such as when people switch from pricier goods to lower-cost alternatives. CPI weightings, meanwhile, are only updated once a year.

That's great for the Fed, but why does it matter for investors? The simple answer is this: What matters to the Fed matters to investors. When the PCE comes in hot, as it has over recent months, the central bank is more reluctant to lower interest rates. That is reflected in forecasts among economists, many of whom have revised their outlooks away from rate cuts through the end of the year.

Understanding the PCE-CPI Wedge

Despite their differences, the two measures have moved largely in tandem over the past 25 years, reflecting the fact that PCE relies heavily on CPI data. Still, they can paint slightly different pictures of inflation, with PCE typically running about 40 basis points, or 0.4 percentage point, below CPI, on average.

That "wedge," as economists typically refer to it, has consequences for the Fed's rate decisions. As inflation surged in 2021 and 2022, lower PCE readings created less urgency for the Fed to raise rates and counteract what it at the time referred to as transitory inflation.

Still, Preston Caldwell, senior U.S. economist at Morningstar, says that teasing out the impact of the PCE-CPI gap isn't as simple as swapping one for the other over a particular period. "The counterfactual only makes sense if the Fed was targeting CPI all along [the inflation target was formally introduced in 2012], in which case inflation expectations would probably have been somewhat lower going into the pandemic," he says.

The dynamic between PCE and CPI is also subject to change. Beginning in November, the usual relationship has reversed, with PCE coming in between 10 to 40 basis points higher than CPI each month.

Economists disagree on which sector is primarily driving that wedge. Caldwell said that housing, which is more heavily weighted in CPI, is probably the largest single driver of the recent reversal. "Over the past 1 1/2 years, housing inflation has slowed by around two percentage points, driving around 0.3 percentage points in PCE inflation reduction but a larger 0.6 percentage point [change] in CPI inflation reduction," he says.

Pfajfar argues that while housing typically drives the PCE-CPI wedge, recent shifts in information technology, which is more heavily weighted in PCE, are likely the primary force behind the current reversal. But those broad weightings don't tell the whole story. Even within IT spending, PCE and CPI have different weights on specific subsectors.

Computer software and accessories, which has seen nearly 12% inflation over the past year, makes up a larger share of PCE's information technology sector. CPI gives more weight to smartphone prices, which have deflated over the past year.

The Cleveland Fed's Center for Inflation Research is projecting month-over-month PCE to increase 0.58% in March, nearly 30 basis points below the latest CPI figure.

Stephen Brown, chief North America economist for Capital Economics, wrote in a recent note that most of the factors driving the "unusual situation of core PCE inflation being higher than core CPI inflation should reverse by the turn of the year."

Write to Elijah Nicholson-Messmer at elijah.nicholson-messmer@barrons.com

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(END) Dow Jones Newswires

April 24, 2026 21:31 ET (01:31 GMT)

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