James Bullard, Essay: Making Sense of Inflation Measures

“The CPI, which rose 8.5% in July 2022 from a year earlier, measures the price changes for a basket of goods and services purchased by the typical urban consumer. The items in this basket are weighted by their relative importance in consumer expenditures. For example, housing—rent and other spending on shelter—accounts for 33% of the index, while medical care accounts for nearly 9%.”

“Of course, any price index like the CPI has to take into account changing consumption patterns. New items come in and old items leave. Currently, the CPI weights are adjusted every two years using two years of consumer spending data; beginning next year, however, the BLS will update weights annually using one year of data.”

“Before 2000, the Federal Open Market Committee (FOMC) typically watched the CPI to gauge inflation. But in the 1990s, the Federal Reserve took a careful look at alternative inflation measures and decided that it preferred a different measure: the headline personal consumption expenditures (PCE) price index. Though the two indexes are closely related, there are reasons why the PCE is considered a better tool for policymakers.”

“The PCE price index, which rose 6.3% in July 2022 from a year earlier, is derived from a broader index of prices than the CPI’s more narrow set of goods and services. The argument that carried the day was that a more comprehensive index of prices provides a better way to gauge underlying inflationary pressures. Because the PCE includes more goods and services, the index’s weights for particular items will differ from those in the CPI. For example, housing has a weight of about 16% in the PCE price index versus 33% in the CPI.”

“Another advantage in tracking the PCE is that the index’s weights are updated monthly, versus biennially for the current CPI. Thus, the PCE can quickly reflect the impact of new technology or an abrupt change in consumer spending patterns.”