2 Indices: The Battle over How Bad Inflation Isn’t

If you’re looking for a gauge on U.S. inflation, you’ve got two primary options. There’s CPI – the consumer price index. And there’s PCE – personal consumption expenditures. Both CPI and PCE serve as broad measures of inflation (i.e. how much prices are going up on consumer goods and services). That’s useful information if you’re trying to predict economic activity, because rapid and unexpected inflation can be bad for economic growth. So, what would you say if I told you that while CPI and PCE generally track in the same direction, there is a difference between the two estimates? And what if I told you that in March 2013, that difference hit its highest level since the start of the 2008-2009 recession? In March, core CPI showed 1.9% year-over-year growth, while core PCE showed a 1.1% increase over the same period. Sure, it’s only a difference of 0.8%, but 0.8% could mean the difference between extending quantitative easing and wrapping it up. 0.8% could mean the difference between projected growth and a return to recession.

The Federal Reserve prefers inflation to be around 2% –that is the sweet spot for price growth used by most central banks around world. The PCE is the Fed’s preferred method of measuring inflation; they feel it more accurately captures actual spending in the economy.  The core PCE hit the Fed’s 2% target only once since November 2008 – in April 2012 – and has been plummeting ever since that time.  The failure of the PCE to sustainability hit 2% target is part of the reason for the Fed’s continuation of the QE.

So what’s the difference between the two? CPI estimates out-of-pocket expenses for consumers. The Bureau of Labor Statistics goes out into the field asks households on their spending.  The PCE price index comprises Bureau of Economic Analysis and BLS prices indexes and tries to capture all spending. “All spending” means spending by households and on behalf of households. There are differences in how items are weighted, and the actual “basket” of goods measured differs between the two – CPI uses a fixed basket of market goods that’s updated every couple years, while PCE reflects actual goods and services purchased every quarter.

And why the 0.8% difference, you’re asking?  Housing and medical expenses probably make up the majority of the difference. You see, housing prices make up a bigger chunk of CPI (31% versus PCE’s 16%), so the recent increases in home prices will have a bigger effect on CPI. On medical expenses, CPI measures out-of-pocket expenses (what you pay on your medical care) while PCE measures both out-of-pocket spending and what your employer spends on your medical care. PCE also weights medical expenses much higher than CPI (20.5% versus 6.2%, respectively).

When you consider that medical spending growth has been slowing and home prices have been increasing, it’s apparent that CPI – relative to PCE – is overstating the increase in home costs and understating the fall in medical expenses. Boom – there’s most of your difference!

The final question of “which index is better” depends on what you’re looking for. If you’re looking for what households expect their inflation to be, then CPI is probably the better index because it uses actual out-of-pocket expenses to measure inflation. Most people don’t factor in what their company’s portion of their health care bills when they’re estimating how much their prices will go up in the future. If you’re the Federal Reserve and have a wider eye for rising prices, then PCE should be (and is) the preferred measure.

Lastly, like the Economist’s Free Exchange blog (sourced above at “medical expenses”), I’d suggest that if you take CPI as your preferred gauge of inflation, then being closer to 2% than 1% is a good thing. Deflation (i.e. negative inflation) is particularly bad for economies because when you’re expecting prices to be lower tomorrow, you’re going to hold off on purchases today. And that can be a spiral it can take years (or in Japan’s case, decades) to get out of.

 

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