Two Measures of Inflation: July 2025
News Summary
As of July 2025, the core Personal Consumption Expenditures (PCE) Price Index stands at 2.9% and the core Consumer Price Index (CPI) at 3.1%, both remaining above the Federal Reserve's 2% inflation target. The Federal Reserve prefers core PCE as its primary inflation gauge due to its exclusion of volatile food and energy prices, and its historical tendency to be less volatile than core CPI, making it a more reliable indicator for assessing underlying inflation trends. Despite the Fed holding rates steady at 4.25%-4.50% for the fifth consecutive meeting, its statement indicated that inflation remains "somewhat elevated" while reaffirming a strong commitment to returning inflation to its 2% objective. Historically, core CPI has generally registered higher readings than core PCE, averaging 0.48% higher since 1960. As of July 2025, this gap has narrowed to 0.18%, but both measures suggest inflation may be stalling above the target.
Background
The Federal Reserve's dual mandate includes achieving price stability and maximum employment, with a long-term inflation target of 2%. The Personal Consumption Expenditures (PCE) Price Index is the Fed's preferred measure of inflation, especially core PCE, which excludes volatile food and energy prices. Prior to 2021, inflation generally remained below 3%. However, the COVID-19 pandemic triggered the highest inflation rates since the early 1980s, with core PCE peaking at 5.57% in February 2022 and core CPI at 6.63% in September of the same year. While both have since declined, current inflation data suggests a potential stalling above the Fed's target, even after multiple rate hikes.
In-Depth AI Insights
What do current inflation levels imply for the Fed's future policy path? The Federal Reserve's fifth consecutive rate hold, despite core PCE and CPI remaining above the 2% target, suggests that the "last mile" of disinflation is proving more challenging than anticipated. This implies: - Policy Patience, Not Pivoting: The Fed is likely to maintain a wait-and-see approach, emphasizing data dependency rather than rushing into rate cuts. While the Trump administration might favor looser monetary policies to stimulate the economy, the Fed will likely prioritize maintaining its anti-inflation credibility. - "Higher for Longer" Rate Environment: Markets should brace for policy rates to remain in the 4.25%-4.50% range, or even higher, potentially through late 2025 and into 2026, exerting sustained pressure on borrowing costs and corporate earnings. - Inflation Expectation Management: The Fed will closely monitor inflation expectations to prevent consumers and businesses from entrenching high inflation perceptions, potentially through tougher communication, even if actual policy actions remain cautious. How does the narrowing gap between core PCE and core CPI influence market interpretation of inflation? Historically, core CPI has consistently been higher than core PCE, but the gap has now narrowed to 0.18%. This could mean: - Converging Signals, Yet Potential Policy Dilemma: While the Fed primarily focuses on PCE, CPI more directly impacts public perception. A narrowing gap suggests greater consensus between the two key metrics regarding inflationary pressures, which theoretically should simplify communication. However, if both converge at elevated levels, it reinforces the signal of sticky inflation, making the Fed more hesitant to cut rates. - Subtle Shifts in Consumer Behavior: The narrowing gap might reflect adjustments in consumer spending patterns, such as increased spending on services, which has a larger weight in PCE. Investors should monitor shifts in consumer spending composition and their implications for sector-specific profitability. How should investors adjust strategies in this "sticky inflation" environment? Persistent above-target inflation and a hawkish Fed stance signal a specific investment landscape: - Focus on High-Quality Defensive Assets: Companies with strong pricing power, stable cash flows, and low debt, alongside defensive sectors like consumer staples and utilities, tend to be more resilient in a high-interest-rate environment. - Attractive Short-Term Fixed Income: Short-term Treasury bonds and high-grade corporate bonds, yielding attractive rates, offer relatively safe and appealing income streams while minimizing interest rate sensitivity. - Commodity Market Volatility: Although core inflation excludes food and energy, overall inflationary pressures can still transmit to commodity markets, including agricultural products. Investors might consider hedging tools like agricultural ETFs, but should be wary of their inherent volatility. - Caution on High-Valuation Growth Stocks: A sustained high-interest-rate environment typically disfavors high-valuation growth technology stocks that rely on future cash flows, as their valuations are more sensitive to the discount rate.