Given that inflation is a key factor in nearly every decision made by the Federal Reserve, it’s crucial to understand its composition and how it impacts fiscal and monetary policy. CPI (Consumer Price Index) and PCE (Personal Consumption Expenditures) are both measures of inflation, but they have some differences in composition, coverage, and usage.
Coverage
- CPI: It measures changes in prices paid by urban consumers for a basket of goods and services. It reflects the out-of-pocket expenses of households.
- PCE: It measures changes in prices paid by households for goods and services. PCE includes expenditures by households, nonprofit institutions serving households, and the government on behalf of households.
Composition
- CPI: It uses a fixed basket of goods and services, thus the quantities and types of items in the basket are relatively constant over time. CPI, only includes medical items purchased out-of-pocket by households.
- PCE: It uses a flexible basket of goods and services, which is updated regularly to reflect changes in consumer preferences and spending habits. This makes PCE more adaptable to changes in consumption patterns. PCE encompasses the cost of all medical goods and services procured through employer-provided insurance, alongside public programs like Medicare
Usage
- CPI: The federal government uses the CPI to make inflation adjustments to certain kinds of benefits, such as Social Security. CPI tends to hew more closely to consumers’ actual out-of-pocket spending, which is one reason why it is most often used to calculate inflation-adjusted wages.
- PCE: FOMC focuses on PCE inflation in its quarterly economic projections and also states its longer-run inflation goal in terms of headline PCE. The Fed favors this gauge because the expenditure weights in PCE can adjust to reflect shifts in consumer behavior. Additionally, PCE offers broader coverage of goods and services, and its historical data can undergo revisions beyond seasonal adjustments, enhancing its reliability.
