Inflation is measured by price indices; the Fed's decisions depend on expected inflation, not just realized inflation. The gap between the two is where much of macroeconomic uncertainty lives. Understanding both is a working literacy for reading any Fed communication.
- 01Distinguish CPI, PCE, and core versus headline.
- 02Explain what breakeven inflation is and how it is measured.
- 03Read the Fed's Summary of Economic Projections on inflation.
The indices
CPI is what most Americans see in the news. PCE is what the Fed targets, because it is broader and updates weights more frequently. Core excludes food and energy; the Fed watches core because food and energy are volatile and can obscure the trend.
Expected inflation
Breakeven inflation is the spread between nominal Treasuries and TIPS of the same maturity. It reflects the market's expected inflation over that horizon. Survey-based measures — the Michigan survey, the New York Fed's SCE — provide a household view. All three are watched.
Why it matters
Wage and price setting depend on expectations. If workers and firms expect 4% inflation, they act on that expectation and produce it. If they expect 2%, they produce something closer to 2%. Anchoring expectations is the Fed's single most important product.
- Fed targets core PCE. CPI is the headline.
- Breakeven is the market's expected inflation.
- Expectations are the Fed's product.