Today, the Bureau of Economic Analysis (BEA) released its report on Personal Income and Outlays with data including January 2024, the most visible of which is the Personal Consumption Expenditure (PCE) price index. While the Bureau of Labor Statistic’s (BLS) Consumer Price Index (CPI) gets most of the attention, and is released in a more timely manner, it is the PCE price index, or rather the inflation rate calculated from the PCE price index, that is the Federal Reserve System’s target for monetary policy.
The CPI with data through January 2024, and specifically the CPI for All Urban Consumers (CPI-U), was released on February 13, and by that measure the year-over-year inflation rate, measured over the twelve months from January 2023 to January 2024, was 3.1%. The PCE price index released today measures inflation over the same period at 2.4%.
The Federal Reserve System targets the inflation rate to be 2%, measured by the twelve-month change in the PCE price index. This latest reading shows a continuation of the gradual decline in this measure of inflation since the 7.1% reading in June 2022. For that matter, the CPI inflation measure has also declined from its recent high of 9.0% in June 2022 to the 3.1% reading mentioned above for January 2024.
The CPI and PCE price index are both intended to measure the level of prices paid by consumers, but they differ in several ways. The PCE price index is a broader index that includes prices for some items not directly paid by consumers but paid on behalf of consumers. A prime example is medical services. The CPI includes out of pocket expenditures by households for medical services. The PCE price index includes medical services for consumers that are paid by employer-provided health insurance and by Medicare and Medicaid. Given this, the weights attached to the various items included in the two indices differ, in part because the PCE price index includes more items that must be assigned weights. Even among similar items, the weights used in the two indices can differ, as they are calculated from different surveys, different sources. Finally, there is a technical difference in how the two indices are constructed, as the CPI uses a “Laspeyres” formula that is easier to construct in a timely manner, while the PCE price index is based on a “Fisher-Ideal” formula. Economists in general prefer the Fisher-Ideal formula on theoretical grounds, but the Laspeyres formula can be implemented more quickly and easily.
How much do these differences matter? The answer depends on for what purpose you are using a price index. For monetary policy, the PCE price index is the announced target. We might ask, if the PCE price index was hitting the Federal Reserve System’s announced target, what would we expect to be the CPI measure of inflation? If we look at historical data, the CPI measure of inflation tends to run about 0.4% higher than the PCE measure. From January 2001 to January 2024, the CPI inflation measure would say we have had 2.5% annual inflation. The PCE price index measure of average annual inflation over this same period is 2.1%. We might conclude that if the Federal Reserve System achieves its 2% target for PCE inflation, the CPI measure will run about 2.4%, on average.
There are more wrinkles, of course. At times the Federal Reserve System talks about the PCE inflation measure less food and energy items, sometime labeled as “core PCE” inflation. The idea behind looking at inflation less food and energy is that energy prices and to some extent food prices are commodities with the potential for large price swings that lead to periods where the more inclusive inflation measures are temporarily high or low, arguably distorting the picture of the longer-term, underlying inflation rate. A further wrinkle is that there is a core CPI inflation measure as well.
The BEA releases data on the core PCE price index at the same time as the main or “headline” PCE price index. Core PCE inflation over the past twelve months ending January 2024 was 2.8%, rather higher than the headline figure of 2.4% mentioned above. As for the CPI, core CPI inflation was 3.9% as compared to the headline figure of 3.1%. This indicates that food and energy prices have been moderating over the last twelve months and have served to reduce the measure of headline inflation. Leaving out food and energy prices actually leads to higher measured inflation.
In any case, the prices consumers are actually paying are measured by the headline price index, whether it be the CPI or the PCE price index. Core measures might be useful for forecasting future inflation (although that is a matter of ongoing debate) but by leaving out food and energy they do not measure all the prices consumer are paying.