Understanding Inflation: CPI, PCE, and PPI

What It Measures

The Consumer Price Index tracks the prices urban households pay for a basket of goods and services: food, energy, housing, transport, medical care, recreation. The Bureau of Labor Statistics collects around 80,000 prices a month and publishes the index monthly. Housing costs make up roughly a third of it.

Headline vs. Core

CPI comes in two flavors:

• Headline CPI: Includes all items (food, energy). Volatile, headline-grabbing. "CPI at 3.2%" usually means headline.
• Core CPI: Excludes food and energy. Smoother, shows underlying trend inflation. Fed pays closer attention to core.

Why Core vs. Headline Diverge

Energy prices swing wildly (geopolitics, OPEC, seasonal demand), creating noise in headline CPI. In June 2022, headline CPI inflation hit 9.1%, pushed up by energy prices after Russia's invasion of Ukraine, while core was about 6%. As energy prices fell back, headline inflation dropped quickly, but core stayed high for longer. The Fed kept raising rates until July 2023, watching core rather than headline.

Market Impact

CPI above expectations → bond yields tend to rise as markets expect higher interest rates → shares of fast-growing companies, whose value depends most on distant profits, have often fallen most → market measures of expected inflation rise. Below expectations → the reverse. CPI releases, Fed decisions and the monthly jobs report are among the biggest scheduled market events.

Why the Fed Prefers PCE

The Fed's official target, adopted in 2012, is 2% inflation in the PCE price index, not CPI. Why? PCE is broader: it also counts spending made on households' behalf, such as employer-paid health insurance. Its weights update as people switch between products, and it gives housing a smaller weight than CPI does. Result: PCE inflation has tended to run around 0.3–0.5 percentage points below CPI inflation.

PCE vs. CPI: The 2022 Gap

In September 2022, core CPI inflation peaked at 6.6% while core PCE was a little above 5%. Most of that gap came from housing: rents were rising fast, and housing carries about twice the weight in CPI that it does in PCE. Lesson: when the two measures diverge, look at what is driving each one before deciding which tells the truer story.

Fed Communication

When the Fed Chair describes inflation as "sticky" or "moderating", the reference point is PCE, especially core PCE. The further it sits above 2%, the more reason the Fed has to keep rates high; as it approaches 2%, room to cut grows. Because CPI and PPI come out first each month, analysts use them to estimate the PCE figure before it is published.

Lead Indicator for Consumer Inflation

PPI measures prices at the producer level (finished goods, intermediate goods, raw materials). It is published monthly, usually within a day or two of CPI. The idea: rising producer prices squeeze margins, and firms may pass some of those costs on to consumers over the following months.

PPI as an Early Signal

If PPI surges (e.g., from 2% to 4%) while CPI is still moderate, analysts start to expect higher consumer inflation in the following months, as producers pass costs on. That is why professionals treat PPI as a possible 2-3 month lead on CPI, though the link is not exact.

The 2% Sweet Spot (Goldilocks)

When inflation runs 2-2.5%, conditions are usually benign: growth is steady, real rates aren't negative and savers earn a yield. Historically this has been a supportive backdrop for shares, with stable bonds and muted commodities.

High Inflation (>3%)

What has tended to happen:

• Held up better: real assets (commodities, inflation-linked bonds, energy and materials shares)
• Struggled: long-duration bonds (negative real returns) and growth stocks (higher discount rates)
• Mixed: financials (helped by higher rates, hurt when the yield curve flattens)

Deflation Risk (<0%)

What has tended to happen:

• Held up better: long-duration bonds (prices rise), growth stocks (lower discount rates), technology
• Struggled: commodities (demand weakens) and financials (near-zero rates squeeze lending margins)
• Under pressure: borrowers, because debt grows heavier in real terms when prices fall

How Markets React to CPI Surprises

CPI above expectations → markets price in higher-for-longer rates → bond yields rise. CPI below expectations → markets bring forward expected rate cuts → bond yields fall. The 10Y yield typically moves 5-15 basis points on release day, and occasionally much more: it fell close to 30 basis points on the soft CPI report of November 2022.