One Says 2.4%, Another Says 3.1%. Which Inflation Metric Is Right?

The Labor Department’s measure makes headlines. The Commerce Department’s measure, released Thursday, is what the Fed watches

By Justin Lahart of The WSJ. Excerpts:

"the central bank bases its 2% inflation target on the inflation data that comes out with the Commerce Department’s monthly report on income and spending. That is known as the personal-consumption expenditures price index, or PCE.

PCE prices run cooler than the CPI, and lately the gap between the two has been especially large."

"overall consumer prices rose 0.3% in January from December, putting them up 2.4% from a year earlier. In contrast, the January CPI was up 3.1% from a year earlier."

"PCE prices excluding food and energy items—the “core” figure that policymakers and economists watch in an effort to better understand inflation’s underlying trend—rose 2.8% in January from a year earlier. That compares with a 3.9% increase in core CPI. While core PCE almost always runs cooler than the core CPI, the difference between the two has rarely been so wide. In the 60 years before the pandemic, their median gap was just 0.4 percentage point."

"The biggest difference between the CPI and the PCE price indexes is their composition. The price weights for different items in the CPI depend on how much of their spending consumers say they devote to different items, based on annual surveys. The price weights in the PCE are based on what Commerce Department data suggest where money actually gets spent."

"Commerce Department data show that Americans devote about twice as big a share of their spending to alcohol as the Labor Department figures. A late 1990s shift in the Fed’s focus toward the PCE index was driven by a view that the spending data was more accurate than the survey data."

"One place where price-weight differences have mattered a lot lately is housing. In the CPI, shelter costs for homeowners and renters account for about 34% of the index’s weight. They account for only about 15% of the PCE. 

Rising shelter costs contributed about two percentage points to the CPI’s 3.1% increase in January. In contrast, those costs added less than one percentage point to PCE inflation."

See also Personal Consumption Expenditures Price Index from the Commerce Department.

Related posts: 

How Does The Fed Prefer To Measure Inflation? (2015)

Some differences between the CPI and the PCE (measures of inflation) (2023)

The CPI was up 0.4% in October (2022) 

Excerpt from that last post:

See 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.

PCE stands for personal consumption expenditures price index. Excerpts from the WSJ article:

"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."