A comparison of the CPI and the PCE price index

Federal Reserve Bank of Kansas City - Economic Review, Third Quarter 1999 by Clark, Todd E

In the United States, there are two broad indexes of consumer prices: the consumer price index, or CPI, and the chain price index for personal consumption expenditures, or PCEPI. Because the indexes are similar in many respects, the inflation rates measured with them often move in parallel. There are, however, some important differences, which, at times, can lead to large gaps between CPI and PCEPI inflation rates. In 1998, for example, the CPI rose 1.5 percent, while the PCEPI increased just 0.7 percent. The discrepancy was even larger excluding food and energy prices: the core CPI grew 2.4 percent in 1998, while the core PCEPI rose just 1.2 percent.

Such gaps between CPI and PCEPI inflation rates raise a simple question: Is one index better than the other? From a monetary policy perspective, an index could be superior in two respects. First, one of the price indexes might be a more accurate measure of inflation today and in the very recent past. To gauge progress toward price stability over the past year, for example, a policymaker would like to know if either the CPI or PCEPI more accurately measures consumer price inflation today. Second, one of the indexes could be a superior measure of historical inflation rates. A policymaker would probably want to use the better historical indicator for gauging long-term price trends and developing inflation forecasting models.

Because some observers have recently suggested the PCEPI may be a better price index, this article examines whether the PCEPI is truly superior to the CPI. The first section reviews the differences in the construction of the indexes. The second section examines the advantages and disadvantages of the CPI and PCEPI. The article concludes that, while some observers might weigh the many pros and cons of the indexes differently, with recent improvements the CPI is the better price index.

I. DIFFERENCES BETWEEN THE CPI AND PCEPI

The CPI and PCEPI measure, in different ways, the average change in the prices of goods and services purchased by consumers. Because the indexes are broadly similar, CPI and PCEPI inflation rates generally move together (Chart 1). However, large discrepancies sometimes occur. For example, the largest gap of the 1990s occurred in 1996, when CPI inflation was 0.9 percentage point higher than PCEPI inflation (Q4/Q4). Such discrepancies in measured inflation are due to differences in the construction of the price indexes. Specifically, the CPI and PCEPI differ in formula, scope, weights, prices, and the treatment of revisions.1 The core CPI and core PCEPI, often viewed as less volatile indicators of inflation trends, vary in the same ways, so this article focuses on the overall price indexes.

Formula

The CPI and PCEPI use different formulas to measure average price change. The Bureau of Labor Statistics (BLS) constructs the CPI as a fixed-weight average of prices for individual goods and services, based on a Laspeyres formula defined in the accompanying box (U.S. Department of Labor 1997). In particular, the index measures the change in the cost of the typical set of goods purchased by consumers in some base period. Historically, the base-period market basket of the CPI has been updated about once every ten years. Since January 1998, the index has been based on 1993-95 purchasing patterns. Beginning in 2002, the BLS will update the market basket every two years (U.S. Department of Labor 1999).

The Bureau of Economic Analysis (BEA) constructs the PCEPI with a chain-weight Fisher Ideal formula (Seskin and Parker).2 The index is an average of two different fixed-weight measures of overall price change. In measuring inflation from the past year to the current year, one fixed-weight index uses the past year's composition of purchases to weight individual price changes, while the other index uses the current year's purchases to weight individual price changes. By averaging the two fixed-weight price indexes, the PCEPI allows for broad year-to-year changes in the basket of goods and services purchased by consumers. Particularly, the index allows for shifts across general categories of goods, such as from oranges to apples.

Scope

In addition to using different formulas, the CPI and PCEPI cover distinct sets of goods and services. Reflecting differences in measurement objectives, the PCEPI is broader in scope than the CPI.3 The BEA produces the PCEPI, along with other data such as gross domestic product, as part of the National Income and Product Accounts. The price index measures the average change in the prices of purchases classified as personal consumption expenditures (PCE). Personal consumption generally refers to spending on goods and services by U.S. residents and the nonprofit institutions, such as welfare and religious organizations, serving them (Seskin and Parker; U.S. Department of Commerce). PCE also includes some consumption funded by government agencies, such as medical expenses covered by Medicare and Medicaid. In addition, PCE is defined to cover the estimated value of certain items consumers obtain without explicit charge. These items include free financial services, such as checking accounts, and employer-funded medical care and insurance.