What Different Measures of Inflation Tell Us

Inflation

Inflation


By Dan Sichel·August 3, 2022

Wellesley College

The problem:

To measure inflation—the rate of change in the price level—we need to compare the prices of a basket of goods and services over time. Although this idea seems simple in principle, measuring inflation in practice is more complicated. The composition of the chosen basket of items whose prices are to be monitored over time and the way in which the prices of these different components are combined may vary from one inflation indicator to another. That being said, no matter how you measure it, inflation is the highest it has been in the United States in decades. Some measures of inflation aim to capture changes in the overall cost of living, while others aim to assess a more general trend. Moreover, the rate of inflation experienced by different households and different sectors of the economy can vary significantly.

Some measures of inflation aim to capture changes in the overall cost of living, while others aim to assess a more general trend.

Facts:

  • The most widely observed and reported measure of inflation is the Consumer Price Index (CPI), compiled by the Department of Labor’s Bureau of Labor Statistics (BLS). In June 2022, the headline CPI indicated that prices were 9.1% higher than a year earlier, a 40-year high. Inflation as measured by the CPI has jumped since the middle of last year – at rates well beyond what most forecasters expected when the economy emerged from the pandemic (see chart) . Inflation was pushed higher by a perfect storm of factors – supply chain disruptions, spending that outpaced the economy’s ability to produce goods and services fueled in part by massive stimulus government, and food and energy price shocks related to the war in Ukraine. Versions of the CPI are used to index social security benefits, some wage contracts and some US government bonds. The CPI is also used more informally to gauge changes in the cost of living by households, businesses, analysts and the media.
  • By design, official measures of inflation like the CPI capture the experience of an “average” urban household, and many people experience higher or lower inflation than reported by published indices. CPI inflation is calculated by combining information about the price changes of many different goods and services with expenditure share data that reflects the importance or weight of each item in overall household expenditure” average”, as determined by a consumer survey. For example, food has a weight of 13.4%, while housing has a share of 32.3%. Since few households have spending habits that match the average, most households experience a rate of inflation that differs from the official measure. For example, food and housing in general represent a larger share of the budget of low-income households. In times of relatively modest price changes for most items, these weighting differences have little effect on individual inflation rates. But, as the prices of these items have recently increased, many low-income households have experienced higher inflation over the past year than higher-income households. In addition to differences in spending shares, different households shop at different stores and this variation can also contribute to differences in realized inflation. Given concerns about increasing income inequality, expanding the ability to estimate price indices defined by income quintile or decile is an important area for future research (see report by the National Academies of Science, Engineering, and Medicine). Other differences in spending shares may also be important, such as older households tending to spend more on medical care and only a subset of households paying school fees.
  • Since food and energy prices are frequently influenced by particular factors – such as weather events or geopolitical instability – and can be quite volatile, analysts often focus on what is known as the core inflation, which measures the rate of inflation for all items other than food and energy. . In many circumstances, when food and energy prices jump, the basic measure provides a better reading of the underlying inflation trend. With the war in Ukraine, energy prices jumped 41.6% in June from a year earlier and food prices rose 10.4%. These large movements have significantly increased the overall CPI. The core CPI – which excludes food and energy prices – rose 5.9% in June from a year earlier, but this rate was well below the headline inflation rate of 9, 1%. While the headline CPI continued to rise in June, when food and energy prices rose, the base rate was down from its peak at the start of the year (though still remained at levels not seen since the early 1980s). At the same time, people have to buy food and fuel regularly, while purchases of other items can be deferred. The main measure is therefore important for understanding the evolution of purchasing power over time.
  • While the CPI has the most public significance, the Federal Reserve prefers a different measure – the Personal Consumption Expenditure (PCE) Price Index – which provides a better measure of overall price changes. This measure is compiled by the Commerce Department’s Bureau of Economic Analysis (BEA) and is an input to the BEA’s Gross Domestic Product (GDP) calculation. The PCE index differs from the CPI in two important ways that make it a preferable measure. First, it uses a formula to combine (or aggregate) the prices of different items that better capture changes in shopping habits when consumers shift their purchases away from items experiencing large price increases or toward sale items. Second, it covers a broader set of elements. The CPI focuses on household expenditures and only tracks the prices of items purchased directly by households (known as outlays). So, for example, medical care provided by an employer is not covered by the CPI. In contrast, the PCE price index tracks the prices of all items consumed by households as it is the relevant concept for addition to GDP. Accordingly, the PCE index would include employer-provided medical care. These differences in aggregation formula and coverage are important reasons for the Federal Reserve’s preference for the PCE index.
  • Given the differences between the measures, PCE and CPI inflation can differ significantly. Indeed, the last reading on year-over-year PCE price inflation was 6.8% for the overall index and 4.8% for the core index, rates lower than those of the overall CPI of 9.1% and the core CPI of 5.9% for the same period. An important reason for this difference is that the shares of food, energy and housing expenditure are smaller in the PCE index than in the CPI because PCE includes items that are not in the CPI and this dilutes the share of other elements.
  • The Federal Reserve has a 2% inflation target for the PCE headline price index. On a PCE basis, current inflation readings are well above the Fed’s target (but not as far behind CPI inflation) and as a result, the Federal Reserve has raised rates of interest to slow the economy and reduce inflation. The basic mechanism is that higher interest rates aim to reduce spending. The effects will be felt particularly in sectors where borrowing is often involved to finance purchases, including housing, other large consumer purchases such as cars and business investments. Indeed, the housing sector already seems to be slowing down. Spending cuts should, over time, bring aggregate demand back into balance with the economy’s ability to produce goods and services, and this balance should lead to lower inflation.

By any measure, inflation has surged over the past 18 months with rates well above the Federal Reserve’s 2% target. Although the headline CPI has received the lion’s share of media attention, other measures of inflation are important and serve different purposes. The main differences include what is covered by the index and how the prices of different items are combined to construct an overall index. Additionally, some measures capture the overall change in the cost of living, while others focus more on the underlying inflation trend. Another important aspect of official inflation measures is that they are designed to capture inflation for the “average” household, and most households’ experience of inflation will differ from that reflected in the official measures.

Topics:

Economic statistics / Inflation

Abdul J. Gaspar