(Bloomberg) -- The unusually wide gap between the two main US inflation gauges is poised to narrow in the months ahead, giving Federal Reserve officials more cover to pause interest-rate increases in early 2023.
Over the last several months, annual inflation as measured by the consumer price index has exceeded that of the personal consumption expenditures price gauge by the most since the early 1980s. Excluding food and energy, the difference in so-called core inflation is also the widest in decades.
Data out Thursday are forecast to show the core PCE price index, which the Fed counts as a preferred inflation gauge, decelerated in October to 5% from a year earlier. Core CPI, which came out earlier this month, cooled to 6.3%.
But some of the measurement quirks that have put more distance between the two metrics are set to fade in the coming months, while others are set to kick in and contribute to a narrowing. That will help inflation ease toward the central bank’s 2% target. Economists generally expect the core gauges to settle back into a 3-3.5% range by the end of 2023.
“The convergence is going to be important for Fed policy next year and driving the discussion” because “you’re going to get less of those red flags coming from the CPI report,” said Jeremy Schwartz, senior US economist at Credit Suisse.
“Because CPI is sending the strongest hawkish message right now, it will count extra that it’s slowing down, and catching down to PCE,” he said.
Here are a few of the most important things to watch in coming inflation reports to track progress as the gap closes:
Conceptually the two gauges measure different things.
The CPI aims to capture out-of-pocket spending by Americans, leading to notable weightings for things like rent and cars. But the PCE tries to measure the costs of everything we consume, whether households directly foot the bill or not. The result is big differences in the weightings of categories, and in which costs are included in the measure.
This is most notable in regard to health care. Unlike the CPI, the PCE includes all health care spending, including by employers on behalf of workers as well as taxpayer-funded programs like Medicare.
As a result, health care makes up nearly a fifth of the core PCE gauge but only around 11% of the core CPI, said Omair Sharif, founder of Inflation Insights LLC.
When taking into account methodology differences, medical care is on track to help bring down the CPI over the next year while the same category is seen as adding to the PCE gauge.
As of the latest CPI report, the health insurance index has already started pulling down core inflation, a reflection of an annual update to the source data. That helps explain a 0.6% monthly decline in the broader medical care services category.
In the PCE, however, medical care will not only be positive but could also accelerate as higher input costs like pay and equipment begin to filter through.
“You really haven’t seen the full force of the increase in labor costs that we’ve seen in the health care sector over the past two years,” said Sarah House, senior economist at Wells Fargo & Co.
Smaller Share, Smaller Deceleration
The other big reason why core CPI is seen decelerating much quicker than core PCE in 2023 is because more generally, the categories that will help drag down the CPI have smaller weightings in the PCE.
Take housing for instance. The so-called shelter category makes up about a third of the overall CPI and about 40% of the core measure. That makes sense given housing tends to be households’ single-biggest monthly expense.
The run-up in rental prices has filtered into the official government measures with a lag. Similarly, the rapid deterioration in the housing market seen over 2022 will also take time to be reflected in the figures. But when they do, the impact on the CPI will be swift.
The effect on PCE, despite similar measurement, will be much smaller, given the housing components have roughly half the significance they do in the CPI.
“That’s probably the biggest driver of the divergence in the outlook for next year,” said Schwartz, who sees core CPI at 3.5% at the end of 2023 and core PCE at 3.1%.
A similar dynamic is expected with autos. Used vehicles have already turned over, falling four straight months in the CPI. But the category has a smaller weighting in the PCE index.
Food & Financial Services
Inherently there are also a few categories in the core PCE that just really aren’t reflected in the core CPI. One of those categories is food services, accounting for about 7% of the core PCE.
Another is financial services, which measures what consumers may pay a financial advisor or the implicit costs banks charge to hold deposits. The grab-bag nature of it led several economists to emphasize how difficult it is to forecast.
Credit Suisse’s Schwartz said the best predictor tends to just be asset prices. Inflation Insights’ Sharif said his general rule of thumb is when interest rates are rising, these costs tend to add to core inflation.
The underlying distinctions in the two overall price gauges have mattered less amid extremely high inflation. But next year may prove to be different.
“As inflation comes down and the Fed is trying to really calibrate policy back to its inflation target while trying to limit the damage elsewhere to the economy, I think the different measurements will come more into the fore,” House said.
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