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A gap is widening between two key measures of underlying US inflation. Unfortunately for newly confirmed Federal Reserve Chair Kevin Warsh, the one rising faster is the central bank’s preferred gauge, further squashing any hope for interest rate cuts. The Bureau of Economic Analysis last week released April’s personal consumption expenditures (PCE) figures, one of two closely watched measures of price changes across a wide range of goods and services. The other is the consumer price index (CPI).
Annual headline PCE inflation rose to 3.8% from 3.5% in March, on the back of soaring energy prices. Core inflation, which strips out volatile food and energy costs, rose to 3.3% from 3.2%. These numbers were in line with expectations, but are still uncomfortable for Warsh. Annual measures of headline and core PCE and CPI inflation have been above 2% for more than five years, and President Donald Trump’s tariffs and the Iran war now seem likely to extend that to six years and beyond.
Crucially, a wedge is developing between core PCE, which is now up to 3.3%, and CPI, which is running at 2.8%. It’s a rare phenomenon which will trouble policymakers the longer it persists, and frustrate President Donald Trump, who has made no secret of his desire to see rates cut.
In general terms, PCE is the broader of the two as it covers urban and rural communities, while the CPI only includes urban households. The PCE index also includes expenditures made on behalf of consumers, such as employers’ health insurance payments. In the three decades through the Covid-19 pandemic, core PCE was always below 3% and rarely rose above core CPI.
But this relationship has flipped in recent months. One major factor may be the AI boom. Dean Maki, chief economist at hedge fund Point72, notes that computer software and accessories have a much larger weighting in the core PCE index. This series is rising at an annual rate of around 14%, lifted by the AI capex splurge this year.
If the latest AI capex forecasts for some $800bn in spending this year are accurate— a rise of 80% on the previous year, according to Morgan Stanley — then this source of pressure on prices is unlikely to ease any time soon. Another factor is the classification of food prices. Core CPI excludes all food purchases, while the core PCE index includes “food services, that is food purchased for off-premises consumption,” as the Cleveland Fed describes it. This latter category of food prices away from home rose 3.6% in April, Maki notes.
The Philadelphia Fed’s closely watched quarterly survey of professional forecasters shows core PCE this quarter is expected to average an annualized 3.4%, up from a previous forecast of 2.7% – a higher inflation outcome and bigger upward revision than the equivalent core CPI forecasts. This may explain why Warsh has indicated an openness to looking beyond core PCE. He has indicated a preference for the Dallas and Cleveland Feds’ “trimmed mean” inflation gauges that remove extreme price moves at the margins to give a clearer picture of how underlying prices change from month to month.
For years, especially during the Alan Greenspan Fed era in the 2000s, it was widely assumed that the benchmark for the Fed’s 2% inflation target was annual core PCE. But according to the Fed’s website, the 2% target is now “measured by the annual change in the price index for personal consumption expenditures.” That suggests policymakers are looking at headline PCE, although confusingly, both measures have become interchangeable among Fed officials, economists and market participants in recent years.
