Measuring US inflation

With the likelihood and timing of any Fed decision to taper bond purchases depending in part on the outlook for inflation, investors have followed US price developments closely in recent months. The central issue from the Fed’s perspective is whether the recent increase in inflation will require a tightening of monetary policy to return it towards the 2% level or if it will do so on its own.

The behaviour of CPI and PCE inflation
US authorities publish two indices that can be used to measure inflation. The first of these is the Consumer Price Index, CPI, published by the Bureau of Labor Statistics. The second price index is the deflator for Personal Consumption Expenditures, PCE, published by the Bureau of Economic Analysis.

As Figure 1 shows, inflation computed using these two price indices behaves somewhat differently. While it is sensible for market analysts to look at both measures, it is important to be aware of the differences and why they arise.

How do the CPI and PCE measures differ?
 

• The formula effect. The PCE is computed using a Fisher ideal index that captures the fact that as the price for a good rises, consumers buy less of that good. By contrast, the CPI is computed using a Laspeyres index that uses weights, that only rarely change, taken from a designated base period. As noted by the Fed, the CPI index therefore tends to overestimate the rate of inflation.
• The weight effect. The weights in the PCE are derived from business services while those used in the CPI are derived from consumer surveys. Importantly, shelter is much more important in the CPI than in the PCE.
• The scope effect. While the CPI reflects the price of out-of-pocket expenditures made by urban consumers, the PCE price index reflects the price of expenditures made by all households, including expenditures made on behalf of households. It is therefore a broader index which, all else being equal, tends to reduce its variability.

The recent behaviour of CPI and PCE inflation
Given these differences, it is not surprising that CPI and PCE inflation provide different perspectives of the run-up in inflation during the spring. With PCE inflation about four-fifths of CPI inflation and being less volatile, PCE inflation has risen less than CPI inflation.

Interestingly, it has also peaked earlier: the month-on-month change rose gradually from 0.3% in January, reached 0.6% in April and fell to 0.5% in June. In contrast, CPI inflation rose from 0.3% in January to 0.9% in June, before falling to 0.5% in July. While PCE inflation may be leading CPI inflation in the present situation, generalising from this episode is hazardous.

Since CPI inflation for July has been released, but PCE inflation has not, we can use the fact that the two series are correlated to provide a forecast of monthly PCE inflation in July of 0.35% and year-over-year inflation of 3.9%. As with all forecasts, it is surrounded by considerable uncertainty.

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