The Fed's Favorite Inflation Gauge is Helplessly Trailing the Other Government Measure

Difference in healthcare cost calculations is the biggest culprit

Janet Yellen And Christine Lagarde Speak At Institute For New Economic Thinking Conference
Photographer: Andrew Harrer/Bloomberg

Between the government's two primary inflation measures, the Federal Reserve's preferred measure is showing far less promise of rising to the central bank's goal. 

The core index of the personal consumption expenditures gauge is now lagging its more popular counterpart, the consumer price index, by the most since the recession ended in June 2009.

The core PCE gauge, which excludes volatile food and energy costs, increased 1.2 percent in April from a year earlier, marking the smallest 12-month gain since February 2014, Commerce Department figures showed Monday. The corresponding CPI measure rose 1.8 percent in April from the same time in 2014. The resulting 0.6 percentage-point difference is the biggest in almost six years: 

The widening spread between these two core measures makes it trickier to gauge whether the Fed officials can be "reasonably confident" — a phrase from their statement — that inflation has enough upward momentum for them to raise interest rates this year. Most economists still expect the central bank to announce in September the first increase in the benchmark interest rate since 2006, according to Bloomberg survey data.

While Fed officials track the headline PCE gauge to judge how far inflation remains from meeting their 2 percent goal, the core measure has been helpful in determining underlying price pressures since the plunge in energy costs in the second half of last year weighed heavily on both the PCE and CPI. Fed Chair Janet Yellen has said that while inflation at 2 percent (something that hasn't happened since April 2012) is not a prerequisite for raising the benchmark interest rate, the policy makers want to see prices in an upward trajectory before making the move.

The divergence in the two core measures can be blamed largely on the healthcare figures. While health is typically the most significant share of the core PCE gauge, it makes up less than 10 percent of the core CPI.

The variance in how each index calculates health costs contributes to the wider gap in April. While the CPI covers Americans' out-of-pocket spending on healthcare, the PCE measure is impacted by congressionally administered costs for Medicare and Medicaid, Paul Ashworth, chief economist at Capital Economics in Toronto, said in a research note last week. 

"Over the past few months, the declines in those administered prices have been covering up a sharp pick-up in the price of out-of-pocket medical care," Ashworth wrote May 28. "The Fed should be wary of putting too much emphasis on the PCE measure of core inflation, particularly at a time when it is being temporarily depressed by declines in government-set prices for health care."

Medical care costs in April climbed 2.9 percent year-to-year in the CPI index, while the PCE gauge showed a 0.6 percent gain over the same period. 

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