In the world of global financial markets, one of the most anticipated economic data every month is the US inflation report. Whenever inflation data is published, the currency, gold, stock and bond markets can move aggressively in just a few minutes.
Most investors usually focus more on the Consumer Price Index (CPI) because this data often triggers great volatility in the market. But in fact, the Federal Reserve (Fed) pays more attention to another less popular inflation indicator, Core PCE.
The question is, why does the Fed trust Core PCE more than the CPI? Why is this difference so important for traders and investors to understand?
What is CPI?
The CPI or Consumer Price Index measures changes in the prices of goods and services that consumers pay every day. It includes the prices of food, oil, rent, transportation, medicine and various other basic necessities.
Because this data is published earlier each month, the CPI is often the first indicator of the current inflation situation in the United States. That is why the market usually reacts very aggressively when the CPI figure is higher or lower than expected.
If the CPI rises sharply, it will provide support for the USD currency and US government bond yields. However, commodity and stock markets tend to decline.
In other words, the CPI is a 'market mover' because it has a very large emotional and sentimental impact on global investors.
Why Does the Fed Focus More on Core PCE?
Although the CPI is more popular, the Fed actually uses the Core PCE or Personal Consumption Expenditures Price Index as the main reference for their monetary policy.
Core PCE is considered more accurate because its data scope is broader because it closely examines changes in consumer behavior, a figure that is less volatile and more flexible in measuring real inflation.
Unlike the CPI, Core PCE is also not too affected by sudden changes in food and energy prices which are often temporary.
Why Do Traders Need to Understand This Difference?
Many traders only look at the CPI because it has a very quick impact on the market. But understanding Core PCE can help investors read the true direction of the Fed more accurately.
In the current situation, the Fed is still very cautious because they do not want to repeat the mistakes of the inflationary era of the 1970s where interest rates were cut too early before inflation had really subsided.
So even though the market is very obsessed with CPI, the actual decision on interest rates still depends a lot on how Core PCE moves in the coming months.
