Asset Allocation Bi-Weekly – The PCE Makeover (8/7/26)

The Federal Reserve's preferred inflation gauge is getting a makeover, and the result may please investors who would benefit from interest rate cuts, which is probably a majority of investors. Confluence Associate Market Strategist and Certified Business Economist Thomas Wash joins Phil Adler to look into how this change may play out for the markets.

What is Confluence Podcasts?

Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays), and a new monthly Q&A format called the Confluence Mailbag.

Phil Adler: 00:04

Welcome to the Confluence Investment Management Asset Allocation Bi-Weekly report. I'm Phil Adler. The Federal Reserve's preferred inflation gauge is getting a makeover, and the result may please investors who would benefit from interest rate cuts, which is probably a majority of investors. Confluence associate market strategist and certified business economist Thomas Wash joins us today to look into how this change may play out for the markets. Thomas, the Fed is said to prefer the price index for personal consumption expenditures or PCE for clues about inflation.

Phil Adler: 00:40

Why does the Fed value this particular index?

Thomas Wash: 00:45

Thank you for having me. So there are probably a number of reasons why the Fed prefers the PCE price index, but I think it mainly comes down to the methodology. The PCE price index accounts for substitution effects, which the CPI does not. Also, unlike the CPI, which relies on consumer expenditure data is updated annually, the PCE price index relies on personal consumption data that is updated more frequently, making it more accurate at capturing changes in spending patterns.

Phil Adler: 01:10

Is an update for an inflation index like this a common event?

Thomas Wash: 01:16

So a methodological updates are actually quite routine. The BEA conducts annual comprehension updates to refine data sources. What makes this update notable is that it addresses specific structural quirks. In particular, it removes distorted spillover effects where massive AI driven hardware and memory chip demand unintentionally spilled over into the consumer price consumer software index.

Phil Adler: 01:40

Why is it happening right now?

Thomas Wash: 01:43

What's driving the change now is concern that the previous methodology was outdated leading to distortions in the readings ultimately producing higher inflation readings than would otherwise be the case. These changes are designed to ensure the index reflects the price pressures households are actually facing.

Phil Adler: 02:00

Well, what has been this index's message in recent months?

Thomas Wash: 02:04

Inflation has remained stickier than expected. Headline PCE has been pressured upwards by energy market volatility and Middle East trade route disruptions. Meanwhile, core PCE, which strips out food and energy, has been hovering above 3%, well clear of the central bank's 2% target. This persistence has fueled debate over when the Fed can safely ease policy.

Phil Adler: 02:26

Thomas, what components in particular are getting the eagle eye right now as possibly contributing to an overestimate of actual household spending?

Thomas Wash: 02:37

The updates will include several components that are believed to have a disproportionate impact on the PCE price index. The most significant change will be to portfolio management. Although the BEA is also expected to adjust estimates for legal services as well as computer software and related accessories.

Phil Adler: 02:54

Let's look at the portfolio management category first. Many people save for retirement by investing in portfolios which charge a fee based on the account's value. Now portfolio values have been rising sharply along with the stock market recently, and so fees have been rising correspondingly. How would the inflation calculation change for this category?

Thomas Wash: 03:17

So previously, the VA tracked portfolio management costs as a percentage of assets under management. So when stock markets rally especially driven by the mega cap tech and AI stocks, portfolio values jump causing measured fees inflation to surge mechanically even if fee rates didn't change. The new method shifts toward measuring industry revenue relative to the volume of services actually rendered eliminating that stock market feedback loop.

Phil Adler: 03:49

The other influential category getting a retrofit is computer software and accessories. Why might this category currently be overestimating actual consumer inflation?

Thomas Wash: 04:02

That's a great question. So the software index will be broadened to reduce its current concentration and prices heavily influenced by surging demand for memory chips. This will include incorporating a wider range of components including video game software and web hosting services, which has experienced more modest price changes resulting in a more representative measure of underlying trends.

Phil Adler: 04:26

Thomas, if these changes in the

Thomas Wash: 04:28

way the index is calculated go through as expected possibly as early as next month, What might be the impact on the overall PCE index? The net revision should exert modest downward pressure on core PCE. Wall Street estimates suggest portfolio management changes could lower year over year core PCE by roughly 0.15 to 0.2 percentage points and software adjustments could shave off another 0.1 points. Although legal services adjustments may slightly nudge inflation up, the net effect is expected to trim core PCE by 0.1 to 0.2 percentage points.

Phil Adler: 05:07

So would this give Federal Reserve Board members room to delay rate hikes and and maybe even to cut rates?

Thomas Wash: 05:16

Not automatically. A statistical reduction of 0.2 percentage points doesn't suddenly bring 3% core inflation down to the 2% target. However, it does signal to the FOMC that underlying price persistence over the past year wasn't quite as aggressive as previously reported, making the path back to target look slightly more achievable.

Phil Adler: 05:36

Thomas, these proposed changes seem driven by the outsized inflationary impact of a rising stock market. How would these changes affect the index if we see a market reversal?

Thomas Wash: 05:49

With the shift away from fees tied to assets under management, a market reversal will no longer exert the same downward pressure on inflation. As a result, factors that previously boosted inflation during the equity rally are unlikely to symmetrically pull it lower during a market contraction.

Phil Adler: 06:06

Just a few more questions. I I wonder if there are some categories in this index which may be underestimating price inflation and are not getting adjusted. What do you think?

Thomas Wash: 06:17

Well, I think that's always been an issue. Critics have routinely pointed to hedonic quality adjustments. When goods like cars or electronics get safer or faster, statistical agencies adjust prices downward to reflect increased value. While technically sound, consumers in the real world still have to pay higher sticker prices on the showroom floor regardless of those quality upgrades.

Phil Adler: 06:40

Well, the question I just asked, I guess, suggests I, myself, may not entirely trust this process. Am I alone, or is there a growing element of mistrust in both government and private statistics now commonly built into investment strategy.

Thomas Wash: 06:58

Personally, I think skepticism usually peaks when inflation remains stuck above target for an extended period. Whenever methodology changes result in lower inflation, critics question whether the benchmark is being moved. However, these revisions are routine, data driven recalibration by career statisticians designed to fix known structural bugs in the data.

Phil Adler: 07:19

Thomas, surely the Fed relies on much more than just this index for inflation clues even if it is preferred. What are other inflation readings investors should watch for?

Thomas Wash: 07:30

Investors should keep an eye on the CPI for direct out of pocket consumer cost pressures, the employment cost index for wage push inflation, and private sector high frequency transaction data to catch trend shifts before they show up in official government releases.

Phil Adler: 07:46

Thank you, Thomas. The title of this week's report is the PCE makeover, and you can find a link to the written report dated 08/03/2026 on the Confluence webpage, confluenceinvestment.com. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. Also, this information does not constitute a solicitation or an offer to buy or sell any security.

Phil Adler: 08:11

Our audio engineer is Dane Stole. I'm Phil Adler.