Thursday, April 23, 2015

How Does The Fed Prefer To Measure Inflation?

CPI vs. PCE: Untangling the Alphabet Soup of Inflation Gauges-Fed’s preferred measure of consumer-price growth may not be the one you think, but both have their place by Jo Craven McGinty of the WSJ. Excerpts:
"But when the Fed reviews economic conditions to decide what actions it will take to influence inflation and employment, it sets aside the century-old measure [CPI] in favor of something called the personal consumption expenditures price index [PCE].

The PCE includes a broader range of expenditures than CPI. It’s weighted according to data provided in business surveys, rather than the less reliable consumer surveys used to weight the CPI. And it uses a formula that adjusts for changes in consumer behavior that occur in the short term, something the standard CPI formula doesn’t do.

The result is a more comprehensive, if less familiar, gauge of inflation. That’s important for the Fed, which regards a small amount of inflation as a sign of a healthy, growing economy."

"Like CPI, PCE tracks changes in real prices paid by consumers for goods and services, but the two indexes differ in several important ways. For starters, the CPI, which typically is slightly higher than the PCE, captures only what urban consumers spend out-of-pocket for a common basket of goods and services.

“It represents what an average consumer buys in a typical year,” said François R. Velde, a senior economist with the Federal Reserve Bank of Chicago. “If it costs $1,000 this year and $1,200 the following year, it gives you an idea of how much the value of money has gone down.”

PCE, on the other hand, includes all goods and services consumed in the U.S. whether they are purchased by consumers or by employers or federal programs on behalf of consumers.

Medical expenses provide a good example of the differences in approach the gauges take. The CPI includes only the co-payments paid directly by consumers in its calculation, while the PCE captures co-payments as well as costs covered by employer-provided insurance and government programs."

"PCE, which is published by the U.S. Commerce Department’s Bureau of Economic Analysis, is derived from retail-sales data collected in business surveys, and in this data, medical care tends to carry the greatest weight. The CPI, on the other hand, is derived from consumer purchases reported in household surveys. Typically, consumers report spending more on shelter than anything else, giving that category more weight in the CPI."

"The CPI uses fixed weights generated from a basket of goods that is updated every two years, which doesn’t allow for the introduction of new products or price changes in the interim that might cause consumers to substitute one item for another.

The PCE accounts for this by using chained weighting. For example, if apples suddenly become very expensive, consumers may not buy as many. As a result, the apples will have one weight in one reporting period, and a different weight in the next. The chain-weight index essentially takes the average of the two."

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