Published on August 3, 2022

Inflation 101

Inflation 101: An Introduction

During periods of high inflation, everything from grocery shopping or filling up your gas tank, to buying a drink at your favorite bar can feel like a hole being burned in your pocketbook. This phenomenon becomes all-encompassing and sometimes self-fulfilling as consumers rush to make purchases before prices continue to rise. Amidst a seemingly endless upward spiral, one may wonder, who is able to measure these price changes and how are they able to do it?

In this insight – Inflation 101 – we discuss two main ways to calculate the changing costs that consumers pay for everyday goods and services. The first method is the Consumer Price Index for All Urban Consumers (“CPI”) developed by the Bureau of Labor Statistics (“BLS”). The other is the Personal Consumption Expenditures (“PCE”) price index created by the Bureau of Economic Analysis (“BEA”).

The CPI measures the change in prices paid by urban consumers for a market basket of consumer goods and services, whereas the PCE price index measures the change in prices paid for goods and services by U.S. households.

Generally, the CPI receives more publicity as it is used to calculate purchasing power, adjust social security payments, and serve as a reference rate for financial contracts. The all-important Federal Reserve, however, expresses its inflation target in terms of the PCE price index.

Acknowledging this dynamic and the similarities and differences between each price index is as important as ever due to the critical role that inflation plays in our day-to-day lives.

Inflation 101: The Bureau of Labor Statistics - Consumer Price Index

As an agency of the U.S. Department of Labor, the Bureau of Labor Statistics (the “BLS”) provides statistical guidance to the department and its agencies and works in partnership with those agencies to support their data needs. The BLS measures labor market activity, working conditions, price changes, and productivity in the U.S. economy to support public and private decision-making.

The CPI, produced by the BLS, measures the change in prices paid by consumers for goods and services and is commonly referred to as the most widely used measure of inflation. Each month, the BLS releases thousands of detailed CPI numbers, however, economists tend to focus on the broadest, most comprehensive data point, The Consumer Price Index for All Urban Consumers (“CPI-U”).

The CPI-U captures data for approximately 93% of the total U.S. population and is based on the expenditures of almost all residents of urban or metropolitan areas, including professionals, the self-employed, low-income workers, the unemployed, and retired people, as well as urban wage earners and clerical workers.

The expenditure items cover more than 200 categories and are arranged into eight major groups including food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services.

In calculating the index, prices are collected each month in 75 urban areas across the country from about 6,000 housing units and approximately 22,000 retail establishments such as department stores, supermarkets, hospitals, and other service establishments.

Notably, the CPI produces both unadjusted and seasonally adjusted data, and its components are commonly used to adjust data series for inflation. The CPI is also used to calculate purchasing power, adjust social security payments and cost-of-living wage adjustments, and serve as a reference rate for calculating real yields.

12-month Percentage Change, Consumer Price Index, Selected Categories, June 2022, Not Seasonally Adjusted

Inflation 101: 12 Month Percentage Change In CPI Categories

Source: U.S. Bureau of Labor Statistics, June 2022. "Consumer Price Index."

Inflation 101: The Bureau of Economic Analysis - Personal Consumption Expenditures Price Index

The BEA is an independent agency within the Department of Commerce’s Economic and Statistics Administration. The BEA seeks to promote a better understanding of the U.S. economy by collecting and publishing timely, relevant, and accurate economic data. Statistical measures produced by the agency include gross domestic product, personal income and outlays, corporate profits, and balance of payments.

The BEA reports the closely followed PCE price index every month which is based on data from a wide range of sources including reports from government agencies, administrative and regulatory agency reports, and private organizations, such as trade associations.

The PCE price index looks at the changing prices of goods and services purchased by consumers in the U.S. and is used primarily for macroeconomic analysis and forecasting. The data is found in the Personal Income and Outlays report and includes various data points that track consumer income and spending, which helps provide indications of consumer behavior and overall economic activity.

Consumers spend most of their personal income on personal outlays such as PCE, which is the total value of the goods and services purchased by U.S. residents. The BEA takes this value and compares the total current value to the prior month’s figures and applies a variety of price adjustments and then normalizes the data via a price deflator to obtain the final inflation-adjusted, or PCE index percent change from the prior period.

Personal Income and Outlays, April 2022

Inflation 101: Personal Income And Outlays April 2022

Source: U.S. Bureau of Economic Analysis, April 2022. "News Release."

Inflation 101: Similarities and Differences – CPI vs. PCE

There are four main differences between the CPI and PCE price index with the first difference being the “formula” effect. The CPI-U is based on a Laspeyres index and the PCE price index is based on a Fisher-Ideal index.

The Fisher-Ideal chain-type price index reflects the substitution between goods when one good becomes more expensive relative to another. Thus, if the price of beef rises, shoppers may buy less beef and opt for a cheaper product like chicken. In contrast, the Laspeyres index uses the same basket as before.

The second difference is referred to as the “weight” effect. The relative weights assigned to similar item prices are different because the weights are based on different data sources. The relative weights used in the CPI are based on household surveys and the PCE price index is based on business surveys.

Third, there are differences between the two indices known as the “scope effect”. Certain items in the CPI-U are out-of-scope of the PCE price index, and vice versa. For example, the CPI only covers so-called ‘out-of-pocket’ expenditures whereas the PCE price Index includes indirect expenditures to consumers, such as medical care paid by employer-provided insurance.

There are a few more, mostly minor differences, related to various items including how seasonal adjustments are handled. These are usually referred to as “other” effects. The below chart illustrates the year-over-year percentage changes for each price index.

PCE vs. CPI, YoY Percentage Changes

Inflation 101: PCE Vs. CPI YoY Percentage Changes

Source: Callan. "PCE and CPI. "What's the Difference?"

Inflation 101: Federal Reserve

In January 2012, the Federal Reserve stated at its monthly Federal Open Market Committee meeting that it would use the PCE price index as its primary measure of inflation, preferring it for the following reasons:

The PCE reflects the substitution between goods when one good becomes more expensive relative to another.
The PCE includes more comprehensive coverage of goods and services.
The PCE data can be revised more extensively than the CPI, which can only be adjusted for seasonal factors and only for the previous five years.

If not for the CPI and PCE price indices, consumers, businesses, and policymakers would be unable to quantify the changes in goods and services from one period to the next. While the CPI and PCE price indices are calculated and measured by different government agencies, they both are intended to measure overall price changes for a group of goods and services over time.

As the Federal Reserve’s preferred inflation gauge, the core PCE price index is the most influential measure in guiding economic policy, providing a more accurate picture of long-term trends. For financial advisors, however, it’s important to understand that your clients must eat and consume energy, suggesting that the headline statistic is more relevant to their day-to-day lives, but when making investment decisions, increased emphasis should be given to the core PCE price index.

Conclusion

Sources: