Measures of Inflation, Tariffs and the Fed

Among the many issues facing the public and financial markets, the impact of President Trump’s tariffs on inflation and how they affect the Federal Reserve’s monetary policy stand out. Estimates of the economic and inflation impacts of the tariffs are quickly evolving as the twists and turns of Trump’s policies change the magnitudes and character of the tariffs. This short note doesn’t speculate on the magnitude of the tariffs, rather it considers how CPI and PCE inflation will likely be affected differently. These differences may influence Fed behavior.

PCE inflation measures the percentage change in prices of all consumer goods and services. This includes all goods, including those paid for by consumers as well as those financed by third party payments like Medicare, Medicaid and medical services paid for by employer insurance. CPI inflation measures the percentage change in prices of goods and services directly paid for by consumers and excludes goods and services paid for by third parties.

As such, PCE and CPI inflation measure the price changes of different baskets of goods and services. PCE inflation is a broader measure of inflation, while the CPI is a better measure of consumer out-of-pocket expenses. The CPI comprises a much larger share 35.4% of shelter costs (including rental costs and owners’ equivalent rent, OER) than the PCE, and a smaller share of medical care (8.3%). Both measures of consumer prices include items like personal care and education expenses.

Of note, both the PCE and CPI inflation measures are adjusted for estimates of quality improvement. The quality adjustments are estimated by the Bureau of Economic Analysis within the U.S. Department of Commerce, based on hedonic regression analyses that try to capture the quality improvements of new products, other estimating techniques, and some degree of subjectivity.

While CPI and PCE inflation are the most widely used measures of inflation, the GDP deflator is a broader measure of inflation that captures the price changes in other components of GDP, including business fixed investment, imports and exports, and residential investment (new construction and home improvements). This is important in the current context, since a sizable portion of imported goods that are subject to tariffs are capital goods purchased by domestic businesses and used in production.

An historical note. The Fed’s semi-annual Monetary Policy Report to Congress and its central tendency projections of economic growth and inflation, which began in 1980 as required by the Full Employment Act of 1978, used the GDP deflator as its inflation measure until 1990, when it switched to the CPI; Fed Chair Greenspan subsequently switched it to the PCE. The Fed’s first-ever Strategic Plan of 2012 officially established the PCE inflation target of 2%.

All other government agencies--and all other central banks in the world--rely on CPI inflation, and the CPI is an important “policy variable” used in various functions, including to index the benefits of Social Security, other pensions and an array of other programs. The Fed began focusing on core inflation early on: Fed Chair Arthur Burns instructed his research staff in the mid-1970s to calculate the CPI excluding food and energy following the spike in agricultural prices in 1971-1972 and surging oil prices generated by the first Arab Oil Embargo in November 1973. His primary interest was to tell the public that the high inflation was caused by exogenous forces. He was also attempting to quell rising inflationary expectations and bond yields without having to tighten monetary policy too much (Remember, before May 1983, mortgage rates were calculated directly in the CPI).

Recent CPI and PCE inflation trends. CPI inflation has been materially higher than PCE inflation in the post-Covid economy, as shown in Chart 1. CPI inflation was 0.6 percentage points higher than PCE inflation in 2024 (3.4% vs 2.8%), 0.7 ppt higher in 2023 (4.8% vs 4.1%) and 0.8 ppt higher in 2022 (6.1% vs 5.3%). So far in 2025, they have tracked closer. The cumulative differences have added up: since December 2019, the CPI index has risen by 3.8 percentage points more than the PCE price index Chart 2). As we all know, the large rise in the general price level has resonated with American citizens and created a communications problem with the Fed.

I expect that the tariffs will have their largest impact on the real economy and a lesser impact on inflation, and their impact on CPI inflation should be larger than their impact on PCE inflation. The Fed is expected to continue to base its monetary policy deliberations on PCE inflation, sidestepping the awkward issue that the CPI inflation has had a more sizable impact on consumers' pocketbooks.

Tariffs are being imposed on imported goods, which in 2024 were only 11.2% of GDP (nominal terms). The impact of tariffs on inflation will be determined by a host of factors, including the exchange rate of the US dollar and how much of the costs of the tariffs are incurred by foreign suppliers, the price elasticity of demand for imported goods and other issues, and the overall impact of the higher taxes on aggregate demand. Two observations are important. First, a hefty portion of the imported goods are durable goods used in manufacturing of products. The net impact of the tariffs on production costs may be incurred by foreign suppliers, reflected in narrower margins of domestic firms, and the extent to which they affect product prices is uncertain.

Second, a sizable portion of U.S. consumption is for non-tradable goods--including shelter (rental costs and OER); medical and health care; education services and personal care and services. Prices of non-tradeable goods will not be directly affected should by tariffs. Their prices may actually recede if increases in prices of tradeable goods rise and reduce aggregate demand in the economy. Of note, the tariffs of 2018-1019 generated a significant slowdown in aggregate demand, and both CPI and PCE inflation remained flat initially and then receded. However, those tariffs were imposed toward the end of a modest Fed rate increase cycle, although the Fed funds rate remained below inflation.

Based on the compositions of the CPI and PCE Price Index, I anticipate that to the extent that tariffs push up inflation, they will have a larger impact on CPI inflation than PCE inflation. They will likely have an even larger impact on the GDP deflator, reflecting the impact of tariffs on prices of imported capital goods, along with the higher prices of imported materials used in residential construction.

While Fed Chair Jay Powell is careful to state that the Fed is aware of the impact of inflation on American citizens, the Fed will continue to focus on PCE inflation in its policy deliberations, while privately cringing if the CPI increases by more. The Fed expects the tariffs will have a one-time impact on the general price level, but it is weary of any rise in inflationary expectations that could become embedded in economic behavior. Market-based expectations have remained fairly stable, with the 5-yr TIPs break-evens around 2.4% and the 5-yr-5-yr forwards 2.3%. The Fed places a higher weight on these than survey-based expectations of inflation that have soared: the University of Michigan 5-year consumer expectations have jumped to 4.4%.

Recommendation. In light of the differences between the measures of inflation and their important influences on public policies, I suggest a national commission of experts should be established to study the measurements of inflation. The last such commission—the Boskin Commission of the mid-1990s—was very fruitful and another one now would be appropriate.

*Mickey D. Levy is a Visiting Fellow at the Hoover Institution at Stanford University and a long-standing member of the Shadow Open Market Committee.