CPI and PCE Measures of Inflation & How to trade it

July 13, 2022 0 By The Balanced Trader

The consumer-price index, a measure of the average prices paid by consumers for a common basket of goods and services that serves as a barometer of economic health, is the most well-known inflation indicator in the United States.

However, when the Fed examines economic conditions to determine what actions it will take to influence inflation and employment, it abandons the century-old measure in favour of something known as the personal consumption expenditures price index.

PCE takes into account a broader range of expenditures than CPI. It is weighted using data from business surveys rather than the less reliable consumer surveys that were previously used to weight the CPI. It also employs a formula that accounts for short-term changes in consumer behaviour, which the standard CPI does not.


source: tradingeconomics.com

What’s the Difference?

The relative weights assigned to comparable items differ because PCE and CPI use different data sources. In 2012, the PCE Price Index became the primary inflation index used by the U.S. Federal Reserve when making monetary policy decisions.

PCE, which is published by the U.S. Commerce Department’s Bureau of Economic Analysis, is derived from retail-sales data collected in business surveys, and medical care is given the most weight in this data. In contrast, the CPI is derived from consumer purchases reported in household surveys. Consumers typically report spending more on shelter than any other category, giving that category more weight in the CPI.

The CPI employs fixed weights derived from a basket of goods that is updated every two years, which does not account for the introduction of new products or price changes that may cause consumers to substitute one item for another in the interim.

Will the Fed raise rates by 50 or 75 basis points in late July? Where is the peak of interest rates, at 3% 3.5% or higher? The answers to these questions depend on whether inflation has already peaked in the US.

Looking at yearly price rises, headline inflation at 8.6% is worrying, but it could get even worse. Economists expect an increase to 8.8% as energy prices continued advancing last month. The price at the pump is propelling prices toward double-digit rises:

How to trade and the market’s reaction to the current data expectations.

July data Expectations source Reuters


A higher number will mean the fed will have to go harder for longer to tame ramping inflation. Higher interest rates and a stronger dollar resulting from higher core inflation. Increased borrowing costs also make saving money more appealing and investing in risky stocks less appealing.

1) Data In-line: If Core CPI MoM comes in at 0.6 percent, the dollar will benefit while stocks will suffer. It would not only demonstrate that price pressures remain elevated, but it would also point to the extension of current market trends. Even a 0.5 percent print, I would argue, would keep the dollar bid and under pressure. Such a scenario would lock in a 75 basis point rate hike while keeping long-term interest rate expectations unchanged.

2) Lower than expected : A 0.4 percent increase would represent an annualised rise of 5%, which is less than the yearly figure, indicating a drop in inflation – that the peak is behind us. The dollar would fall and stocks would rise as a result. A 50 basis point increase in July, rather than a 75 basis point increase, would become a favoured scenario. It would also fuel speculation that the Fed might settle for a terminal rate of less than 3%.

3) Higher than expected: An unexpected increase of 0.7 percent or more would be dire for equities valuations ( remember its inflation is a value deflator) for stocks and will boost the dollar. Investors may even begin to consider inflation is becoming out of control and price in harder action from the fed. The final interest rate to reach +4 percent. It would also fuel fears of a global recession and cause safe-haven flows to the dollar.

Conclusion

Whether it’s CPI or PCE at the moment the markets are acutely focused on these numbers as they gauge the response to rampaging global inflation caused by supply disruptions and covid constraints. All into the backdrop of weakening economic activity and an attempt by the Fed to create a Volker-style mini-recession and dampen demand.

Pay close attention to the data and the market reaction. By the end of the session following the release, a good idea of the market’s grading of inflation and the future path of the fed will likely influence PA into the next fed meeting.

One last thing, the Whitehouse has been recently harping that this data is already out of date with a huge plunge in commodities and has only recently manifested and is unlikely to be reflected in the data. ( As of July 2022 release)

This article will be updated from time to time to reflect the changing scene.