The Fed’s PCE Problem: Why Its Preferred Inflation Gauge Misreads the Economy

The Fed’s PCE Problem: Why Its Preferred Inflation Gauge Misreads the Economy

The Federal Reserve continues to anchor policy to the PCE index, yet a closer look at the mechanics of that measure raises serious questions about whether it reflects the inflation consumers actually experience — or the inflation the Fed can actually influence. With core CPI tracking near 3% and real-time measures running well below it, the case that the Fed is on the verge of a second sequential policy error is stronger than the headline PCE reading suggests.

The Imputation Problem

More than 30% of the PCE index is built on imputed rather than market prices, which introduces distortions that would not survive scrutiny in any market-based benchmark.1 Portfolio management services, for example, are shown rising roughly 21% over the past twelve months — a figure disconnected from what investors are actually paying and driven mechanically by the PPI methodology that ties fees to rising asset prices.2 The BEA also imputes a cost for non-interest-bearing checking accounts that mechanically rises when interest rates rise, because the user-cost methodology values the service as the spread between a reference rate and the rate paid on deposits.3 The result is perverse: if the Fed tightens policy, measured financial services inflation goes up rather than down.

A Weighting Scheme That Does Not Match the Consumer

PCE captures a broad swath of consumption that consumers themselves do not pay for, including government transfers and employer-funded healthcare.4 That inclusion distorts the weightings of every other category. Shelter — the sector where Fed policy has the most direct traction — accounts for only roughly 15% of PCE, compared with 35% of CPI.5 Healthcare, which is driven largely by secular rather than cyclical forces, carries more than 20% of the PCE weighting versus about 10% in CPI.6 The index the Fed watches most closely is therefore the one over which it has the least control.

The Chain-Weighting Rationale Does Not Hold

The Fed has long defended PCE on the grounds that it is chain-weighted, and in principle a continuously updated basket that adjusts for consumer substitution is a superior methodology.7 In practice, that advantage collapses when roughly 30% of the weightings are imputed. There is no consumer response to an imputed price, and if the initial weights are already distorted by non-market consumption, marginal chain adjustments over time do little to correct the underlying problem.

What Real-Time Data Actually Shows

Core CPI is currently tracking near 2.9% year-over-year, well within striking distance of the Fed’s 2% target.8 Our CPI-R index, which uses real-time pricing for shelter and financial services, is running below 1%.9 Core PCE prints at 3.3%, although that figure is heavily distorted by a financial services calculation estimating over 9% inflation and by a shelter component that lags reality by roughly two years.1011 Our PCE-R measure, which substitutes real-time prices for imputed ones, is tracking in line with the Fed’s 2% target.12 The gap between the headline gauge and the measures that reflect what consumers actually

pay is not small — it is the difference between a Fed that appears behind the curve and one that has arguably already overshot.

The Case Against Another Tightening

The Fed should adopt core CPI as its preferred inflation gauge. It measures what consumers actually pay, whereas PCE tracks imputed consumption. Fed policy also operates almost exclusively through interest-sensitive channels — shelter and capital goods — and has little bearing on the secular drivers behind healthcare services inflation.

Against that backdrop, a rate increase at this juncture would represent a historic policy error on par with the “transitory” misjudgment of 2021. Policy is already tight: housing and construction are in recession, and the Fed Funds rate sits 75 to 100 basis points above neutral.13 Core CPI is close to target, and arguably more than 100 basis points below target once the flawed shelter and financial services components are adjusted.

Tightening is appropriate when excessive monetary growth is fueling inflation in interest-rate-sensitive sectors — the environment of 2021, when the money supply expanded roughly 27% year-over-year, the Fed Funds rate ran well below neutral, and home prices rose more than 20% year-over-year.14 Today’s setup is materially different: money supply growth has moderated to roughly 5.6% year-over-year — below its long-run average and a fraction of the 2021 peak — the Fed Funds rate sits above neutral, and home prices are essentially flat in nominal terms and declining in real terms.1516 The data do not support additional tightening. They arguably support the opposite.

Footnotes

1. Bureau of Economic Analysis, NIPA Handbook, Chapter 5: Personal Consumption Expenditures — description of imputed PCE components and financial services furnished without payment, https://www.bea.gov/resources/methodologies/nipa-handbook/pdf/chapter-05.pdf.

2. UBS estimates cited in coverage of the BEA’s 2026 PCE methodology revisions: portfolio management and investment advice services PPI rose approximately 21.6% year-over-year, making it the second-largest contributor to core PCE inflation, https://www.axios.com/2026/07/06/inflation-fed-pce. See also Federal Reserve Bank of Dallas, “What is keeping core inflation above 2 percent?,” September 23, 2025, https://www.dallasfed.org/research/economics/2025/0923.

3. Bureau of Economic Analysis, NIPA Handbook — services furnished without payment by depository institutions are imputed as the difference between a “reference rate” and the rate paid on deposits, applied to average deposit balances. The user-cost methodology mechanically raises measured financial services consumption as interest rates rise, https://www.bea.gov/resources/methodologies/nipa-handbook/pdf/all-chapters.pdf.

4. BEA and BLS working paper, “Rethinking Inflation Heterogeneity,” 2025 — PCE includes expenditures on government-provided health care (Medicare, Medicaid), imputed financial services, and other categories absent from household surveys, https://www.bea.gov/system/files/papers/BEA-WP2025-9.pdf.

5. Bureau of Labor Statistics, “Measuring Inflation: CPI and PCE,” comparison table: shelter carries roughly 15–16% of PCE versus approximately 34% of CPI. See also BEA, “Comparing Price Measures — The CPI and PCE Price Index,” https://www.bea.gov/sites/default/files/papers/P2006-2.pdf.

6. BEA, “Comparing Price Measures — The CPI and PCE Price Index,” medical care carries approximately 20% of PCE versus roughly 6–8% of CPI, primarily reflecting third-party payments (Medicare, Medicaid, employer plans) included in PCE but not in CPI, https://www.bea.gov/sites/default/files/papers/P2006-2.pdf.

7. Federal Reserve Board, “Why does the FOMC target the PCE inflation rate?” — the Committee cites PCE’s chain-weighted formula, broader scope, and historical revisions as reasons for its preference over CPI, https://www.federalreserve.gov/faqs/economy_14400.htm.

8. Bureau of Labor Statistics, Consumer Price Index release — core CPI rose 2.9% year-over-year in May 2026, https://www.bls.gov/cpi/. See also usinflationcalculator.com core inflation table, https://www.usinflationcalculator.com/inflation/united-states-core-inflation-rates/.

9. Infrastructure Capital Advisors, CPI-R real-time inflation index — proprietary measure substituting current market rents and real-time financial services pricing for the CPI’s lagged shelter and imputed components.

10. Bureau of Economic Analysis, Personal Consumption Expenditures Price Index release, June 2026 data — core PCE year-over-year was 3.3%, https://www.bea.gov/data/personal-consumption-expenditures-price-index-excluding-food-and-energy. See also Yahoo Finance coverage of the June 2026 PCE release, https://finance.yahoo.com/economy/articles/june-2026-pce-consumer-spending-124715931.html.

11. Federal Reserve Bank of Dallas, “What is keeping core inflation above 2 percent?,” September 23, 2025 — financial services inflation and lagged shelter measurement remain outsized contributors to core PCE, https://www.dallasfed.org/research/economics/2025/0923.

12. Infrastructure Capital Advisors, PCE-R real-time inflation index — proprietary alternative that substitutes market-based prices for imputed PCE components, tracking in line with the Federal Reserve’s 2% target as of the most recent print.

13. Federal Reserve, Summary of Economic Projections, June 2026 — longer-run federal funds rate (proxy for neutral) at 3.1%; current federal funds rate range 3.50%–3.75%. See also June 2026 FOMC Statement, https://am.jpmorgan.com/es/en/asset-management/institutional/insights/portfolio-insights/fixed-income/fixed-income-perspectives/fomc-statement-june-2026/.

14. Federal Reserve H.6, historical M2 series — year-over-year M2 growth peaked near 27% in February 2021. Case-Shiller National Home Price Index year-over-year growth peaked at 21.3% in April 2022, https://tradingeconomics.com/united-states/case-shiller-home-price-index-yoy.

15. Federal Reserve H.6 Money Stock release; M2 year-over-year growth was approximately 5.6% in May 2026 and 4.7% in April 2026, materially below the >6% long-run average and a fraction of the pandemic-era peak near 27%, https://ycharts.com/indicators/us_m2_money_supply_yoy.

16. S&P Cotality Case-Shiller U.S. National Home Price Index — annual price growth of approximately 0.8% in April 2026 and 1.1% in May 2026, indicating that home prices are effectively flat in nominal terms and declining in real terms, https://www.spglobal.com/spdji/en/index-announcements/article/sp-cotality-case-

About Us

Jay D. Hatfield is CEO of Infrastructure Capital Advisors and is the lead portfolio manager of the Infrastructure Capital Bond Income ETF (NYSE: BNDS), InfraCap Small Cap Income ETF (NYSE: SCAP), InfraCap Equity Income Fund ETF (NYSE: ICAP), InfraCap MLP ETF (NYSE: AMZA), Virtus InfraCap U.S. Preferred Stock ETF (NYSE: PFFA), InfraCap REIT Preferred ETF (NYSE: PFFR) and private funds. Each month Infrastructure Capital hosts a monthly economic webinar; you can sign up to attend by visiting our website www.infracapfunds.com (important disclosures can also be found on the website). For a prospectus please reach out to us or visit the links above for each respective fund.

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