When it comes to inflation measures, the Federal Reserve prefers the PCE
When it comes to inflation measures, the Federal Reserve prefers the PCE
Each month, two flagship inflation gauges get a lot of attention: the consumer price index and the personal consumption expenditures price index. Yet only one gets to be the Federal Reserve’s favorite inflation measure, and that honor goes to the PCE.
That index — which ticked up 6.6% in March from a year earlier, 5.2% excluding food and energy — is put out by the Bureau of Economic Analysis. For Fed officials, it’s a pretty key figure. “That’s the primary inflation measure that the Fed is using to make monetary policy decisions,” said Julie Smith, an economics professor at Lafayette College.
But this wasn’t always the case. Before 2000, Fed officials often relied on the consumer price index.
That started to change in 1996. “There was a big study by the Boskin Commission,” Smith said, “that looked at biases in the consumer price index.”
The commission, which was named after its chair, Stanford economist Michael Boskin, looked at how well the CPI measured the cost of living. It found a few issues, particularly in the way CPI handles what the report called substitutions.
The index’s calculation is based on a fixed “basket” of over 100,000 goods, services and rentals, which are given different weights based on a household survey and tracked over time. While the basket is updated yearly, the way consumers behave can change a lot more frequently.
“That fixed basket doesn’t allow consumers to substitute away from goods and services whose prices are rising,” said Smith. “So it can overstate the actual rate of inflation in the economy.”
That’s where the personal consumption expenditures gauge comes in. “The PCE uses a basket of what we actually buy every month because it’s based on our consumer spending,” Smith said. “It allows us to do what we all do when we go to the grocery store. We say, ‘Oh, these oranges have gotten more expensive, so maybe I’ll buy grapefruit.'”
According to her, the PCE is a broader and timelier measure of consumer behavior than the CPI, and that’s why the Fed prefers it. But being preferred doesn’t mean it’s the only measure Fed officials look at.
“The CPI provides us a lot of information about inflation,” Smith said. “At the end of the day, they’re looking at all of these measures of inflation to make monetary policy decisions.”
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