CPI vs PCE: The Two Inflation Measures and Why the Fed Prefers PCE

Every month two different government agencies publish two different inflation numbers, and they rarely agree. The Consumer Price Index (CPI) from the Bureau of Labor Statistics (BLS) gets the bigger headlines. The Personal Consumption Expenditures (PCE) price index from the Bureau of Economic Analysis (BEA) is the one the Federal Reserve targets. This explainer covers what each measures, why they diverge, and which one matters for what.

The Consumer Price Index (CPI)

BLS describes the CPI as "a measure of the average change over time in the prices paid by consumers for a representative basket of consumer goods and services."

Key features:

• The basket. Spending is grouped into more than 200 categories in eight major groups: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. Weights come from the Consumer Expenditure Surveys, in which thousands of households report what they actually bought.
• Price collection. BLS records prices for about 80,000 items each month, by visits, websites and phone calls to stores, service providers, rental units and doctors' offices.
• Taxes. Sales and excise taxes tied to purchases are included. Income and Social Security taxes are not, and nor are investments such as stocks, bonds and real estate.
• Population. The headline CPI-U covers "all urban consumers", over 90% of the US population. The CPI-W covers a subset of urban wage-earner and clerical households, roughly 30% of the population.
• No routine revisions. Because CPI-U and CPI-W are written into contracts, pensions and tax rules, BLS treats them as final when issued, except for seasonal-factor updates and rare corrections.

What the CPI is used for

Its reach is wide. BLS notes that CPI changes affect the income of more than 108 million people through laws that tie payments to it. Social Security's annual cost-of-living adjustment is based on the CPI-W, comparing third-quarter averages. Federal income tax brackets are also adjusted for inflation each year, and many wage contracts are tied to the CPI.

The PCE price index

BEA's PCE price index measures "the prices that people living in the United States, or those buying on their behalf, pay for goods and services." It is built from the same spending data that feed the consumption part of GDP. BEA says it captures inflation "across a wide range of consumer expenses" and reflects "changes in consumer behavior."

Unlike the CPI, PCE data can be revised as better source data arrive, like the rest of the national accounts.

Why the two numbers differ

BEA publishes a formal reconciliation of the two indexes. It groups the differences into four effects.

1. Formula effect. The CPI uses a modified Laspeyres formula, which essentially prices a fixed basket. PCE uses a Fisher-Ideal "chain-type" formula that updates for shifts in what people buy. When beef gets expensive and shoppers switch to chicken, PCE picks up the switch faster. This is one reason PCE inflation usually runs a bit lower.
2. Weight effect. The two give different importance to the same items. Housing has a much larger weight in the CPI than in PCE, so rent and owners' equivalent rent move the CPI more.
3. Scope effect. The CPI measures households' out-of-pocket spending. PCE covers spending by and on behalf of households, including nonprofit institutions serving households. The biggest practical difference is healthcare. Medical care paid for by employers or by Medicare and Medicaid is in PCE but mostly outside the CPI.
4. Other effects, including differences in seasonal adjustment and in the prices used.

BEA's FAQ gives a worked example. In the third quarter of 2006, PCE prices rose at a 3.0% annual rate and CPI prices at 3.7%. Most of the 0.7-point gap came from the weight effect, mainly housing and gasoline, partly offset by scope differences such as hospital services.

"Headline" vs "core"

Both agencies publish an all-items figure and a version that excludes food and energy, usually called core. BLS explains that some users prefer core because food and energy prices "are relatively volatile" and they want to see the "underlying" rate of inflation. Core is not a measure of what households actually pay. People still buy food and fuel. Core is a tool for judging the trend.

Why the Fed targets PCE

The Federal Open Market Committee (FOMC) says inflation "of 2 percent over the longer run, as measured by the annual change in the price index for personal consumption expenditures," is most consistent with its mandate of maximum employment and price stability. The Fed adds that when households and businesses expect inflation to stay low and stable, "they are able to make sound decisions regarding saving, borrowing, and investment."

The broader coverage and changing weights of the PCE index are the main reasons it is the target. The Fed still watches the CPI closely, partly because it is published earlier in the month.

Reading the release

• Month-on-month vs year-on-year. A 0.3% monthly rise works out to about 3.7% when compounded over a year. Headlines often mix the two.
• Index points vs percentages. The CPI's reference base is 1982–84 = 100. Compare percentage changes, not changes in index points.
• Your own inflation may differ. BLS stresses that the CPI "does not necessarily measure your own experience." A household that spends heavily on rent, or drives a lot, will see a different rate.
• Local indexes. City CPIs measure change over time within that area. BLS warns they cannot show whether one city is more expensive than another.

The short version

The CPI, from BLS, tracks out-of-pocket prices for urban consumers using a basket with fixed weights. It is never routinely revised, and it drives Social Security cost-of-living adjustments and tax brackets. The PCE price index, from BEA, covers a broader set of spending, including spending made on households' behalf such as employer-paid healthcare, and adjusts as buying patterns shift. It is the measure behind the Fed's 2% target. Expect PCE inflation to usually run a little below CPI inflation, and check whether a headline means headline or core, monthly or yearly.

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