How Healthy is the US Consumer: Inflation and Real Wage Growth

With the heavy stream of reminders that inflation is at historic highs, and suggestions that the economy is on the verge of collapsing from one day to the next—it can be difficult to focus on our future goals and feel any sense of security about our own finances. The reality is, however, that expert economists and financial professionals are not guided by sensational news bulletins, and neither should you.

One term that tends to dominate the news cycle is Consumer Price Index (CPI). Often this figure is followed by a statement about consumer prices being at all-time highs—which leads to further commentary on inflation and the deteriorating health of the overall economy. So where does this inflation index come from, what does it mean, and are there other ways to measure consumer prices to gain a different perspective about our economy? The answers to these questions hint at some of the methodologies we work through at Smith Anglin —which include a comprehensive analysis of where the economy is and where it is heading. The purpose of this series is to give you some insight into some of the factors that help us make decisions about how to best protect your money and investments.

Understanding CPI

CPI is the primary inflation gauge that economists, investors, and governmental agencies pay close attention to when evaluating the health of the economy and its effects on consumers. CPI measures changes in the price of a fixed basket of consumer goods and services purchased by households. Think of this fixed basket as a literal shopping basket carrying some 94,000 items the US Bureau of Labor Statistics selected from a sample of goods and services the average consumer buys. The price of this basket represents average consumer patterns, so a higher price indicates higher inflation rates. There are, however, some key issues with this method of measurement, starting with the fact that the items in the basket do not change — but human behavior and buying patterns do.

Although CPI is a great tool to measure trends in the average consumer’s expenses, it falls short of capturing the fact people change their habits over time. Essentially, CPI fails to address optionality and the substitution choices that consumers are free to make. We actively choose to purchase and exchange items that we want for items that we need when money is tight. For example, if beef gets too expensive, maybe we simply substitute beef with less costly chicken. If chicken is too expensive, we may choose to change our diet to exclude meat and poultry altogether. We may not like the options, but they still exist.


Although CPI tends to be given the highest regard in measuring inflation, PCE (Personal Consumption Expenditures) is an additional measure that captures nuances that CPI fails to include in its formula. Unlike CPI, PCE attempts to account for behavioral effects by gathering data about what consumers actively buy and then comparing that data to data from previous time periods.  The US Bureau of Labor Statistics builds its basket of goods by conducting business surveys in large cities across the country.

In contrast, the PCE formula utilizes business surveys, which provide reliable information about the variety of goods and services being sold, and at what prices. Effectively, PCE goes straight to the source to gather the most current samples of goods

and services purchased rather than simply measuring the overall price change of a fixed basket of goods. The result is a more comprehensive and less volatile measure of inflation that reflects our attempts to adapt to an unpredictable economy.

From an application standpoint, a lot still rides on CPI. For instance, the federal government uses CPI to adjust Social Security benefits each year, and the U.S. Treasury Department and capital market participants use it to value numerous types of fixed income instruments. However, when the Federal Reserve is setting monetary policy and determining open market operations, they tend to prefer PCE vs. CPI as they view it as the more accurate gauge of inflation.

CPI vs PCE: The Numbers

PCE and CPI measures have headline and core variants that strip out the energy and food inputs which tend to have high levels of variability month to month and year to year. However, most consumers do not have the option of excluding fuel and food from their spending, so “headline” data tends to be the preferred inflation gauge over “core” inflation data. Economists and analysts compare these inflation measures to Average Hourly/Weekly Earnings + Hours Worked to measure how comfortable consumers are with their spending.

Looking at the current numbers on PCE vs Avg Hourly Earnings which were released on June 30th, we see that Headline PCE YoY (Year over Year) rose by 6.3% while Core PCE (excluding energy) rose by 4.7%, vs Avg hourly earnings which increased by 5.2% in May and 5.10% in June, both YoY) So, overall, earnings did a good job at keeping pace with the higher prices we saw in goods over the past year.

On a month-over-month basis, PCE rose 0.6% (Core PCE 0.3%) and Avg hourly earnings grew 0.4% for May. On a real basis, we are looking at wage growth YoY of -1.1% relative to PCE vs -3.94% compared to CPI. Not to say any of this is looking phenomenal, but to put it into context over the trailing 10 years, prior to the distortion in the labor market by the Covid Crisis, average hourly earnings were rising around 2% annually and PCE saw about an average of 1.5%.

So, on a real basis, the avg wage growth seen in the past decade has been about +0.5% annually. When comparing wages historically to CPI, real wage growth is between  +0.25% to +0.4%with some instances in 2018 where growth was negative (-.25%). (Wage Growth % minus% Change in CPI and or PCE). Noticeably, the spread between CPI and PCE when compared to wages to arrive at “real wage growth” YoY, was much tighter historically vs today, indicating that during normal inflationary times, the difference between CPI and PCE is much less significant. However, during inflationary times like now, the spread between CPI and PCE is much more significant since consumers are more likely to substitute goods during periods of high inflation To be fair, some of this spread is also due to the discrepancies in how particular goods/services are weighted in the index, but the substitution factor is still making its dent in the numbers.

The other factor that needs to be considered is that things look much rosier when comparing wages on a core basis vs a headline. As we stated earlier, consumers don’t have the option of eliminating food and energy expenses just because the price of those goods goes up.  However,  in the US, food and energy expenditures make up a much smaller percentage of the average consumer’s overall budget when compared to other parts of the world.  That said, although the total percent change in price may be great and contribute to a big headline inflation number, if someone is only spending an extra $80 per month on gas over last year, that increase in expenses may not have a large impact on the consumers’ overall budget. This phenomenon is something that PCE aims to capture a better basket of goods that consumers are actually buying. One last consideration here is that both food and energy have experienced tremendous supply chain and production issues recently, which have been the main driver of price increases. So, while the Fed is attempting to get a better picture of consumer demand-driven inflation, the core inflation measure tends to be preferred in this environment.. Supply chain bottlenecks and issues surrounding the Russia-Ukraine conflict will end at some point in the future. When this happens, the overall rate of inflation is very likely to subside and wages will remain elevated. Resulting in a much healthier situation for US consumers.

All Things Considered

In effect, PCE captures a better picture of what the consumer is experiencing during stressful times. In periods like now, when consumers have a higher tendency to substitute, it is wise to consider PCE in any true analysis of inflation before writing off the consumer as “dead in the water”. More importantly, before making drastic changes in our investments because of what we read in some foreboding article, we need to stay informed and recognize the complex nature of our economy and that a lot of the time the answers aren’t really that simple to come by.  It’s also important to note that real wage growth relative to inflation is not nearly as drastic as the media is portraying the inflation problem to be.

Ultimately, it is important to recognize the possibility of a more resilient consumer economy for 2022 despite all the noise out there. Given this, the best strategy is to stay disciplined and stick to the plan for the portfolio that was put in place. Considering some of the nuances of our current environment and that we are not categorically entering a textbook recession, it is appropriate to not be 100% defensive. Unlike the defensive measures taken during the COVID crash of 2020, unemployment is low, and consumers still hold more than $2.5 trillion, much of which is left over from Covid era stimulus programs.

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