What Is the PCE and Why Is It the Fed's Favorite Inflation Gauge?

Mike Maharrey

When people discuss inflation, the Consumer Price Index (CPI) usually gets the most attention. But the Federal Reserve’s preferred inflation measure is the Personal Consumption Expenditure (PCE) index. What is the difference, and why does the Fed favor the PCE?

The two measures use significantly different methodologies, and central bankers prefer the PCE because it tends to show lower price inflation than the CPI.

It is important to note that neither of these metrics measures “inflation” in the historical sense used by economists, meaning an increase in the supply of money and credit. CPI and PCE measure price inflation, which is a symptom of monetary inflation.

CPI

As the name suggests, the CPI measures changes in prices paid by consumers. The Bureau of Labor Statistics produces CPI data using household surveys and price collection.

To calculate the price inflation rate, the BLS uses a “basket” of goods. That basket includes spending categories such as shelter, food, energy, healthcare, and others, based on household surveys. Analysts collect around 80,000 prices from retailers and service providers each month and calculate the change in the price of the entire basket using a complex system of formulas and hedonic adjustments.

This basket remains fixed, generally for about two years, and allows far less substitution between categories than the PCE. Even if the price of beef surges, the formula generally assumes consumers will keep buying the same amount of beef until the next basket update.

Many economists prefer the CPI for long-term planning because it does not attempt to estimate substitution effects, which is an extremely subjective process, and it is rarely revised after publication. That makes it a more stable metric for contracts and cost-of-living adjustments.

However, the CPI has limitations. The formula was adjusted in the 1990s in a way that, according to critics, understates price inflation. Based on the formula used in the 1970s, CPI would be closer to double the official numbers. In that case, CPI would be near 6 percent, and using an honest formula could produce an even higher figure.

PCE

The PCE is a broader measure of prices and is a component of GDP. It includes purchases made directly by households, as well as purchases made on behalf of consumers, such as employer-provided health insurance and spending by nonprofit organizations serving households.

The Bureau of Economic Analysis produces the PCE report.

Rather than asking consumers what they buy, the PCE is compiled from what businesses sold. It draws on a wide range of sources, including Census Bureau retail surveys, manufacturer shipment data, hospital and physician revenues, utility revenues, airline ticket sales, financial services, and other business and government data.

Analysts use this information to estimate total consumer spending in each category. They then weight each category according to actual spending by calculating current expenditure shares, and they update those weights every month.

The BEA also tries to estimate the substitution effect when prices rise. Its formulas assume, for example, that people will buy less beef when the price spikes, and the data will reflect that assumption.

The difference between CPI and PCE can be described this way:

• CPI asks: “How much more expensive is it to buy the same basket of goods and services?”
• PCE asks: “How much more expensive is it to maintain the same overall standard of consumption, even if consumers adjust what they buy?”

That difference matters because the two indexes can tell different stories about the same economy, and the one policymakers emphasize can shape how inflation is discussed in public debate, business planning, and official forecasting.

Why Does the Fed Favor the PCE?

As noted above, the Federal Reserve prefers the PCE. It officially set 2 percent core PCE as its target in 2012.

Why?

Central bankers say the PCE offers broader coverage of consumer spending, that its chain-weighting formula better captures changing consumer behavior, that it is consistent with other data sets including GDP, and that frequent revisions improve accuracy.

That explanation may sound reasonable, but there is a simpler one.

The PCE understates price inflation even more than the CPI.

In other words, it consistently tells a more favorable inflation story. Central bankers prefer that kind of story because if they can convince people inflation is not that severe, they can expand the money supply at a faster pace without provoking as much public backlash.

Over longer periods, the PCE generally runs 0.2 to 0.4 percentage points lower than the CPI.

Both CPI and PCE formulas create multiple opportunities to skew the numbers lower. Each assumption built into the formulas was made by a government functionary with a bias and an agenda.

The PCE’s substitution metrics give analysts a powerful way to make price inflation look more subdued than it really is.

Government officials have a vested interest in presenting inflation as tame. In their view, inflation is not a bug; it is a feature. Their ability to expand the money supply supports large-scale government borrowing and spending. But monetary inflation comes with a serious side effect: price inflation. The better they can obscure that monetary debasement, the longer they can avoid political backlash from the public.

Government number-crunchers also have an incentive to keep measured price inflation as low as possible because the PCE is used to “deflate” GDP. If price inflation is lower, real growth appears stronger.

Government data should always be treated with caution. It is a mistake to assume government statisticians are neutral seekers of truth. The numbers may offer some sense of reality, and they are what we have, so they must be used. But government data always comes with an underlying propaganda motive. That is worth remembering when evaluating the numbers and the official spin.

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Mike Maharrey

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