In a recent examination of the Federal Reserve's approach to tracking inflation, it has been revealed that the central bank may be significantly underestimating the cost pressures faced by American households. Despite recent Consumer Price Index (CPI) data indicating an accelerated annualized rate from under 1% in October to nearly 4%, the Fed has remained notably quiet on the issue.

The root of this silence appears to lie in the Fed's preferred measure of inflation—the Personal Consumption Expenditures (PCE) index—which consistently reports lower figures than the CPI. This divergence is attributed to two critical deficiencies within the PCE's methodology.

Firstly, the PCE's accuracy is called into question as it incorporates government spending, which accounts for nearly half of expenditure in the United States, diluting the impact of consumer spending. This is particularly evident in the housing sector, where rent and housing constitute 35% of the average American's expenditure and the CPI, but only 15% of the PCE. This discrepancy alone is said to shave 1% off the PCE index, and similar gaps exist across other categories such as food, medical care, vehicles, and gasoline.

Moreover, the PCE is affected by a more insidious issue known as substitution bias, a result of its frequent updating of category weights within the expenditure basket. As the prices of certain goods rise, consumers naturally shift to cheaper alternatives, causing the index to underreport inflation since it adjusts the weighting to reflect decreased spending on the now more expensive items.

This bias towards underrepresentation of inflation could lead to the Federal Reserve overlooking escalating prices, potentially resulting in a delayed response to inflationary pressures and jeopardizing economic stability.