PCE and CPI Inflation: Whats the Difference?

At the end of the day, the Fed’s main concern is long-run headline inflation and the prices people actually pay. Monetary policymakers are responsible for maintaining overall price stability, which is usually interpreted as low and stable inflation. In order to decide on appropriate policy actions given their objective, policymakers need to know the current rate of inflation and where it is headed. What makes for a reliable predictor of future inflation has been debated throughout the years and continues to be the subject of economic analyses today. One debate that has received attention recently is whether the focus should be on headline or core inflation.

In November 2023, we did a simple forecasting exercise, comparing the root mean squared errors (RMSEs) from using CPI components and core CPI measures to predict 12-months-ahead headline CPI inflation. We found that core measures of inflation were more accurate than using individual components, even those with the highest predictive content. Headline inflation is a raw figure that reflects changes in the consumer price index (CPI) throughout the entire economy.

1. Of course, if the evidence shows that core PCE is not the best measure to focus on for policy purposes, exploring other options may make sense.
2. The effects on inflation can be brief, meaning they ultimately correct themselves and the market returns to a balanced state.
3. USAFacts standardizes data, in areas such as time and demographics, to make it easier to understand and compare.

Food and energy prices are exempt from this calculation because their prices can be too volatile or fluctuate wildly. Food and energy are staples, meaning demand for them doesn’t change much even as prices rise. For example, gas prices may rise with the price of oil, but you will still need to fill up the tank to drive your car. Similarly, you won’t be putting off buying your groceries just because prices are rising at the store. In this essay, we shift our perspective away from comparisons between core and its components. But the baskets aren’t the same, and it turns out that the biggest differences between the CPI and PCE arise from the differences in their baskets.

CLEVELAND FED DIGEST

Since food and energy are essential items in the household budget, changes in these prices can have a significant impact on consumers’ purchasing power and overall cost of living. In this sense, headline inflation may provide a more accurate reflection of the inflationary pressures faced by households on a day-to-day basis. On the other hand, core inflation may not fully capture the impact of rising food and energy prices on consumers, leading to a disconnect between the inflation measure and consumers’ lived experiences. Core inflation and headline inflation are two important measures used by economists and policymakers to track changes in the overall price level of goods and services in an economy. Core inflation is a measure of inflation that excludes certain volatile items, such as food and energy prices, which can fluctuate significantly from month to month. On the other hand, headline inflation includes all items in the Consumer Price Index (CPI) basket, making it a more comprehensive measure of overall price changes.

Quality Adjustment

Hence, it is considered the price of the basket of all the above products in a particular month compared to the price of all these products in the same month in the previous year. These products are some basic essential requirements whose demand remain stable even if prices fluctuate. For example, transportation costs may rise with the rising price of diesel, but transportation of necessary products has to go on. Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of a given country’s economic health. As the most widely watched measure of inflation, the CPI is used for many purposes, such as indexing Social Security payments.

At the longest horizons, however, core PCE inflation’s advantage disappears and becomes a weakness as the values become firmly positive. Interestingly, at all horizons, the paths start to flatten in May 2023, which suggests that the two forecasts are providing comparably accurate forecasts. Prior to mid-2021, the results largely align with the conclusion in Breitung and Knüppel’s paper. For the shortest two (and perhaps three) horizons, there is predictive content of core PCE inflation beyond just using the benchmark inflation target of 2%. At longer horizons the advantage vanishes, and the two forecasts tend to be equally accurate. Headline inflation is also used for other policy measures and financial instruments.

What Is Headline Inflation and How Is It Related to the Consumer Price Index?

The former is calculated from an all-item index, whereas the latter is commonly calculated from a price index that excludes the highly volatile food and energy components. Inflation is a threat to long-term investors because it erodes the value of future dollars, can stifle economic growth, and can cause a rise in prevailing interest rates. While headline inflation tends to get the most attention in the media, core inflation is often considered the more valuable metric to follow. Both headline and core results are followed closely by investors, and they are also used by economists and central banking figures to set economic growth forecasts and monetary policy. Of course, if the evidence shows that core PCE is not the best measure to focus on for policy purposes, exploring other options may make sense.

Core PCE inflation plays an important role in the U.S. financial system because the Federal Reserve references it to gauge U.S. inflation when setting monetary policy. Headline inflation is often closely related to shifts in the cost of living, which provides useful information to consumers within the marketplace. Headline inflation is the raw inflation figure reported in relation to the Consumer Price Index (CPI), which is released monthly by the Bureau of Labor Statistics (BLS).

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By targeting core inflation, policymakers can avoid overreacting to temporary price shocks and instead implement measures that address sustained inflationary pressures. For example, if core inflation remains low despite a rise in headline inflation due to a temporary spike in oil prices, a central bank might decide to maintain lower interest rates to support economic growth. The choice between using core inflation or headline inflation as a policy tool can have significant implications for policymakers. Core inflation is often used by central banks to set monetary policy targets, as it provides a more stable and reliable measure of underlying inflationary pressures. By focusing on core inflation, policymakers can avoid overreacting to short-term fluctuations in prices and make more effective decisions about interest rates and other policy tools. However, some critics argue that excluding food and energy prices from the inflation measure may lead to a distorted view of inflation and result in policy mistakes.

By excluding these categories, core inflation aims to present a more stable measure of price changes. What would it mean for monetary policy analysis if the FOMC does expect headline and core inflation to continue diverging in 2011 and 2012? As I asserted in my previous commentary, one interpretation is that, during times of continuous increases in the relative price of energy, perhaps core PCE is a misleading indicator of underlying inflation trends. This implies that core PCE may not be a good predictor of future headline inflation after all. Under these circumstances, headline PCE inflation should probably have more weight in policymaking decisions than core PCE inflation. The calculation of headline inflation also involves weighting the different items in the CPI basket according to their importance in headline inflation vs core inflation the average consumer’s budget.