ROI-Rare US core inflation 'wedge' a headache for Warsh's Fed: McGeever

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Jamie McGeever

ORLANDO, Florida, May 28 (Reuters) - A gap is widening between two key measures of underlying U.S. inflation. Unfortunately for newly confirmed Federal Reserve Chair Kevin Warsh, the one rising faster is the central bank's preferred gauge, further squashing any hope for interest rate cuts.

The Bureau of Economic Analysis on Thursday released April's personal consumption expenditures (PCE) figures, one of two closely watched measures of price changes across a wide range of goods and services. The other is the consumer price index (CPI).

Annual headline PCE inflation rose to 3.8% from 3.5% in March, on the back of soaring energy prices. Core inflation, which strips out volatile food and energy costs, rose to 3.3% from 3.2%. These numbers were in line with expectations, but are still uncomfortable for Warsh.

Annual measures of headline and core PCE and CPI inflation have been above 2% for more than five years, and President Donald Trump's tariffs and the Iran war now seem likely to extend that to six years and beyond.

Crucially, a wedge is developing between core PCE, which is now up to 3.3%, and CPI, which is running at 2.8%. It's a rare phenomenon which will trouble policymakers the longer it persists, and frustrate President Donald Trump, who has made no secret of his desire to see rates cut.

A TALE OF TWO INFLATION MEASURES

In general terms, PCE is the broader of the two as it covers urban and rural communities, while the CPI only includes urban households. The PCE index also includes expenditures made on behalf of consumers, such as employers' health insurance payments.

In the three decades through the COVID-19 pandemic, core PCE was always below 3% and rarely rose above core CPI. Economists at Bank of America estimate that PCE has only topped CPI around 11% of the time since 1990.

But this relationship has flipped in recent months. One major factor may be the AI boom. Dean Maki, chief economist at hedge fund Point72, notes that computer software and accessories have a much larger weighting in the core PCE index. This series is rising at an annual rate of around 14%, lifted by the AI capex splurge this year.

If the latest AI capex forecasts for some $800 billion in spending this year are accurate - a rise of 80% on the previous year, according to Morgan Stanley - then this source of pressure on prices is unlikely to ease any time soon.

Another factor is the classification of food prices. Core CPI excludes all food purchases, while the core PCE index includes "food services, that is food purchased for off-premises consumption," as the Cleveland Fed describes it. This latter category of food prices away from home rose 3.6% in April, Maki notes.

"Overall, core PCE inflation looks even further above target than the core CPI, and we think that is likely to remain the case in the coming months," Maki wrote recently.

He's not alone. The Philadelphia Fed's closely watched quarterly survey of professional forecasters shows core PCE this quarter is expected to average an annualized 3.4%, up from a previous forecast of 2.7% - a higher inflation outcome and bigger upward revision than the equivalent core CPI forecasts.

SHIFTING GOAL POSTS

This may explain why Warsh has indicated an openness to looking beyond core PCE. He has indicated a preference for the Dallas and Cleveland Feds' "trimmed mean" inflation gauges that remove extreme price moves at the margins to give a clearer picture of how underlying prices change from month to month.

For years, especially during the Alan Greenspan Fed era in the 2000s, it was widely assumed that the benchmark for the Fed's 2% inflation target was annual core PCE.

But according to the Fed's website, the 2% target is now "measured by the annual change in the price index for personal consumption expenditures." That suggests policymakers are looking at headline PCE, although confusingly, both measures have become interchangeable among Fed officials, economists and market participants in recent years.

On the one hand, this ambiguity could provide the Fed with wiggle room as it balances its interest in maintaining full employment with its focus on price stability.

But the lack of clarity could lead markets to believe that the Fed is simply moving the goalposts - selecting whichever measure best supports the desired policy shift.

At a time when questions about Fed independence are rife, that's a major risk - and one more reason why Warsh's honeymoon period may already be over before it's barely started.

(The opinions expressed here are those of the author, a columnist for Reuters)

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(By Jamie McGeever Editing by Marguerita Choy)