Inflation has been much in the news during the last few years, with notice of whether the rate is up or down a staple of reports. Inflation is the rate of increase in prices over a given period of time. (Historically, prices have rarely decreased; one example of such deflation would be the Great Depression in the 1930s.) It’s definitely a newsworthy topic. The prices you pay for goods and services change all the time; they may move at different rates and even in different directions. Some prices may drop while others are going up.
But how is inflation measured? A price index is one way of looking beyond individual price tags to measure overall inflation (or deflation) for a group of goods and services over time. However, there are several ways to measure inflation.
(Warning: many acronyms ahead!)
In the United States, there are two primary measures of prices paid by consumers for goods and services. One is the Consumer Price Index (CPI), which is produced by the Bureau of Labor Statistics (BLS). The other is the Personal Consumption Expenditures (PCE) price index, prepared by the Bureau of Economic Analysis (BEA).
There is also one other measure of prices paid for by producers of goods and services. That measure is the Producer Price Index (PPI), which is also produced by the Bureau of Labor Statistics (BLS).
The PPI and the CPI
The Producer Price Index (PPI) is a family of indexes that measures the average change over time in the selling prices received by domestic producers of goods and services. The PPI measures price change from the perspective of the seller. This contrasts with other measures such as the Consumer Price Index (CPI) that measures price change from the purchaser’s perspective.
About 10,000 PPIs for individual products and groups of products are released each month. These PPIs are available for the output of nearly all industries in the goods-producing sectors of the U.S. economy—mining, manufacturing, agriculture, fishing, and forestry—as well as natural gas, electricity, construction, and goods competitive with those made in the producing sectors, such as waste and scrap materials. The PPI covers approximately 72% of the service sector’s output, as last measured by revenue reported in the 2007 Economic Census.
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought.
The PPI can serve as a leading indicator for the CPI. When prices rise for producers, as is tracked by the PPI, they tend to pass on those costs to consumers, as is tracked by the CPI.
How It Works
There is a time lag between the expenditure survey and its use in the CPI. The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they bought. For example, CPI data in 2022 was based on data collected from the Consumer Expenditure Surveys for 2019. That year, about 21,000 consumers from around the country provided information each quarter on their spending habits in the survey.
To collect information on frequently purchased items, such as food and personal care products, another 10,000 consumers kept diaries listing everything they bought during a two-week period that year. This expenditure information from weekly diaries and quarterly interviews determines the relative importance, or weight, of the item categories in the CPI index structure.
The CPI reflects spending patterns for each of two population groups: 1) all urban consumers and 2) urban wage earners and clerical workers.
The all-urban-consumer group represents over 90% of the total U.S. population. It is based on the expenditures of almost all residents of urban or metropolitan areas, including professionals, the self-employed, the unemployed, and retired people, as well as urban wage earners and clerical workers.
Not included in the CPI are the spending patterns of people living in rural nonmetropolitan areas, those in farm households, people in the Armed Forces, and those in institutions, such as prisons and mental hospitals. Consumer inflation for all urban consumers is measured by two indexes: namely, the Consumer Price Index for All Urban Consumers (CPI-U) and the Chained Consumer Price Index for All Urban Consumers (C-CPI-U).
One limitation of the CPI is that the CPI cannot be used to measure differences in price levels or living costs between one area and another, as it measures only time-to-time changes in each area. Also, the CPI does not produce official estimates for the rate of inflation experienced by subgroups of the population, such as the elderly or the poor.
The PCE
The PCE price index looks at the changing prices of goods and services purchased by consumers in the United States. The PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and for reflecting changes in consumer behavior. A variation on the PCE is the personal consumption expenditures price index, which excludes food and energy and is also known as the “core” PCE price index. The core PCE index makes it easier to see the underlying inflation trend by excluding two categories—food and energy—where prices tend to swing up and down more dramatically and more often than other prices. The core PCE index is closely watched by the Federal Reserve as it conducts monetary policy.
Blocks and Weights
The building blocks of the PCE and CPI inflation calculations are largely the same. Each index attempts to quantify changes in consumer prices by tracking changes in the prices of a specific basket of goods and services each month. Differences in formulas, weights, scope, and other methods can cause the two indexes to behave differently over time.
The CPI and PCE are constructed using unique index formulas. The CPI relies on a Laspeyres formula, whereas the PCE uses a Fisher-Ideal formula.
The Laspeyres formula used for the CPI is calculated by working out the cost of a group of commodities at current prices, dividing this by the cost of the same group of commodities at base period prices, and then multiplying by 100. This means that the base period index number is always 100.
Named after American economist Irving Fisher, the PCE’s Fisher-Ideal formula expresses the relationship between nominal interest rates, real interest rates, and inflation. This formula is referred to as “ideal” because it corrects the positive price bias of the Laspeyres.
Fisher-Ideal also satisfies both the time-reversal and factor-reversal tests. The time-reversal test requires that, if the prices and quantities in two different periods are being compared as interchangeable, the resulting price index is the reciprocal of the original price index.
When an index meets this test requirement, the same result is derived regardless of the direction of change measured.
The Fisher-Ideal formula is considered more accurate than the Laspeyres formula because it accounts for consumer substitution of goods as relative prices change. For example, as the price of milk goes up, people frequently purchase less milk, which the PCE formula considers. However, the PCE formula depends on more current data, which explains why the PCE releases later than the CPI each month.
The relative weights assigned to each of the CPI and PCE categories of items are based on different data sources. The relative weights used in the CPI are based primarily on the Consumer Expenditure Survey, a household survey conducted for the BLS by the Census Bureau.
The relative weights used in the PCE index are derived from business surveys: for example, the Census Bureau’s annual and monthly retail trade surveys, the Service Annual Survey, and the Quarterly Services Survey. As a result, each inflation metric weighs some things slightly differently than the other. Famously, housing makes up 33% of the CPI but just 15% of the PCE basket.
The CPI measures the change in the out-of-pocket expenditures of all urban households, and the PCE index measures the change in goods and services consumed by all households and nonprofit institutions serving households. This conceptual difference means that some items and expenditures in the PCE index are outside the scope of the CPI. For example, health insurance expenses made on behalf of employees by their employers or by Medicare and Medicaid are included in the PCE basket but not the CPI. These differences can also be isolated and measured and can be referred to as “scope effects.”
The Fed ❤️ the PCE
Since 2000, the Federal Reserve has championed the PCE report as its inflation gauge of choice. The PCE has greater scope, more accurate weighting methods, and uses a more precise formula than the CPI. To that end, economists generally value the PCE as the superior inflation gauge.
However, frequently, it’s the CPI that moves markets. That’s because even though the CPI and PCE tend to follow the same general trajectory, traders are more likely to respond erratically to a surprise CPI reading than the follow-up PCE equivalent, as they’ve already priced in the expected inflation movement. This typically reduces the shock factor of the PCE and dulls market movement stemming from it later in the month.
If you like reading our “Bowen Reports Blogs”, Bowen Asset does have a Facebook page: https://www.facebook.com/BowenAsset Please check it out as we frequently make comments on the page about not just finance and
economic events that happen in between our blogs.
As always, if you have any questions about this report or any other questions, please reach out to Bowen Asset at info@bowenasset.com or (610) 793-1001.
Disclaimer
While this article may concern an area of investing or investment strategy in which we supply advice to clients, this document is not intended to constitute a complete description of our investment services and is for informational purposes only. It is in no way a solicitation or an offer to sell securities or investment advisory services. Any statements regarding market or other financial information is obtained from sources which we and/or our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. All expressions of opinion reflect the judgement of the author on the date of publication and are subject to change.
Past performance should not be taken as an indicator or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. As with any investment strategy or portion thereof, there is potential for profit as well as the possibility of loss. The price, value of and income from investments mentioned in this report (if any) can fall as well as rise. To the extent that any financial projections are contained herein, such projections are dependent on the occurrence of future events, which cannot be predicted or assumed; therefore, the actual results achieved during the projection period, if applicable, may vary materially from the projections.