Understanding the Divergence between CPI and PCE Inflation Measures: A Comprehensive Analysis
Inflation has taken center stage in the political discourse leading up to the November elections. However, despite President Joe Biden’s efforts to bring down inflation to its 2% target, it remains a persistent issue. The Federal Reserve plays a crucial role in this regard, as it is tasked with maintaining inflation at the targeted level. But just how close are we to achieving this goal? The answer depends on which inflation measure you choose to look at.
Two Preferred Inflation Measures: CPI and PCE
The Federal Reserve primarily relies on two measures of inflation: the Consumer Price Index (CPI) and the Personal Consumption Expenditures price index (PCE). While both measures aim to gauge inflation, they differ significantly in their methodologies and scope.
The CPI is a widely known measure of inflation that focuses on the prices consumers pay for goods and services, commonly referred to as the average urban consumer. PCE, on the other hand, looks at prices paid by the government, nonprofit organizations, and consumers from all over the country.
Diverging Inflation Rates: A Deeper Dive into CPI and PCE
The latest Consumer Price Index (CPI) data, released in February 2022, showed a 3.2% increase in prices for the previous 12 months. However, if we turn our attention to the Personal Consumption Expenditures price index (PCE), which is the Federal Reserve’s preferred inflation gauge, prices were increasing at a slightly lower annual rate of 2.4% in January 2022.
The discrepancy between the two measures can be attributed to their varying methodologies and weighting of different sectors. For instance, housing plays a more significant role in CPI (over four times) than PCE. As a result, even small changes in housing prices can have a substantial impact on the overall inflation rate for CPI compared to PCE.
Moreover, the weights assigned to each of the 80,000 items that CPI tracks are updated annually based on consumer expenditure surveys from the Census Bureau. In contrast, PCE’s weights change monthly based on data collected by the Commerce Department. This allows PCE to capture substitution effects more effectively.
Another factor that contributes to the divergence between CPI and PCE is the weighting of gas prices. Gas has a much more significant impact on CPI compared to PCE. For example, from January to February 2022, gas prices rose by 3.8% on a seasonally adjusted basis in CPI, while they fell by 5.2% from December to January for PCE.
The use of Owners’ Equivalent Rent (OER) in CPI and PCE also warrants mention, as it is a widely criticized metric that has been questioned for its accuracy in reflecting housing inflation. Both indexes utilize OER to track housing inflation; however, the difference between OER and rent data was particularly large in January 2022, leading some economists to question the validity of one or both sets of data.
Implications and Conclusion
In summary, while both CPI and PCE serve as valuable measures of inflation, their methodologies and weighting of different sectors result in diverging inflation rates. Understanding these differences is crucial for policymakers and investors alike, as it sheds light on the nuances of inflation and its potential impact on economic conditions.
As we move forward, it is essential to keep a close eye on both CPI and PCE to gain a well-rounded perspective on inflation trends. This knowledge can help inform important decisions related to monetary policy, asset allocation, and overall economic strategy.
