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The Fed's choice of inflation measure increases its bias towards stimulus [ClearOnMoney]
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The Fed's choice of inflation measure increases its bias towards stimulus

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Commentary

The Fed's choice of inflation measure increases its bias towards stimulus

22 Feb 2012 by Jim Fickett.

The Fed's favored measure of inflation, based on the personal consumption expenditure price index, tends to show inflation as 1/3 to 1/2 percentage point lower than the CPI. For this and other reasons, investors should be aiming to get nominal results that will provide a positive return after taxes and average inflation of 3-4%.

It is widely remarked that the Federal Reserve's favorite inflation measure, growth in the personal consumption expenditure price index (less food and energy), often comes in lower than growth in the consumer price index (also less food and energy). While there are no doubt good theoretical foundations for preferring one index or the other, it seems likely, given the Fed's bias towards stimulus, that their preference for the PCE price index is at least partly due to the fact that it gives lower reads on inflation.

I've been meaning for a long time to look at the difference between the two measures quantitatively. Recently a comment from Rich Toscano, of Pacific Capital Associates (on the post Core inflation rose to 2.3% in January) nudged me to do so. Here is the longest series that the two measures have in common, showing, as usual, the inflation rate as the year-over-year change in each price index:

It is clear that:

  • The Fed's favored inflation measure does indeed usually (though not always) give a lower reading
  • There are long periods where it is lower than, and long periods where it is about the same as, the CPI
  • In a few cases (e.g. 1980) the difference between the two measures is quite large

How far off are the two measures on average? Here is a comparison of the average inflation rates (measured as CAGR in the price indices) over a few different periods:

Period Fed CPI Difference
1959 - 2011 3.53% 3.98% 0.45%
1985 - 2011 2.51% 2.87% 0.36%
2000 - 2011 1.98% 2.45% 0.47%
2005 - 2011 2.11% 2.43% 0.32%

Generally speaking, the Fed's measure comes in 1/3 to 1/2 percentage point lower.

It is difficult to explain in any simple way why one measure gives lower readings than the other, because there are many methodological differences. A nice background paper from the BEA (Comparing the Consumer Price Index and the Personal Consumption Expenditures Price Index) attempts to give some flavor of the most important differences. They show that the two differences that matter most are as follows:

Weight effect

The relative weights used in the CPI are based primarily on household surveys, while the relative weights used in the PCE price index are based primarily on business surveys. … The relative weight for rent of shelter in the CPI is about 32 percent; its relative weight in the PCE price index is about 15 percent. …

Scope effect

The CPI measures the out-of-pocket expenditures of all urban households, while the PCE price index measures the goods and services purchased by households and nonprofit institutions serving households within the framework of the U.S. national income and product accounts (NIPAs). … For example, medical care services in the CPI consist only of those services directly purchased by consumers. In the PCE price index, medical care services include services directly purchased by consumers and services paid for on behalf of consumers—for example, medical care services paid for by employers through employer-provided health insurance and medical care services paid for by governments through programs such as Medicare and Medicaid.

Measuring inflation is more complicated that most people realize, and it is difficult to argue details with experts. What is clear is that the CPI does somewhat underestimate changes in the cost of living (CPI and COLA), so the Fed's inflation measure does so even more. And, looking at the measures in the table above, it is also clear that investors need to do well enough to make up for cost of living increases well over the ideal inflation rate of 2% that is often quoted by economists and the Fed.