How is inflation measured: Yahoo U

·3-min read

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If you’ve noticed that the price of the same basketball has increased over time, you’re observing inflation.

Inflation is a major component to macroeconomics with serious implications. High inflation across an economy can rapidly devalue the purchasing power of your dollar. But deflation (when prices decline) can signal a shrinking economy.

For policymakers that therefore want to keep a delicate balance of low but stable inflation, the question is: What’s the best way to measure it?

There are two major data releases that track inflation: the Consumer Price Index (from the Bureau of Labor Statistics) and the Personal Consumption Expenditures Index (from the Bureau of Economic Analysis).

The two indexes are similar, but have slightly different approaches to the way that they calculate aggregate price changes.

What prices are measured by the CPI and PCE figures?

Both indexes measure inflation across the economy, looking at the prices that consumers pay for a basket of goods and services.

Everything from car parts to laundry services to cereal are included in these measures (and are easily searchable on the BEA and BLS websites).

The difference is in the way that the CPI and the PCE weigh certain categories of goods and services.

For example, household cleaning products are part of both the CPI and the PCE baskets, but the weighting may be a little different between them. So if the prices of paper towels or Windex spike, that may have a more outsized effect on the aggregate inflation number in one measurement over the other.

What makes the formula for CPI different from PCE?

The key difference is that the PCE uses a “superlative” index that reflects consumer substitution among items as prices change.

For example, if consumers shift from apples to oranges because apples are getting more expensive against oranges, the PCE will adjust the weightings to account for that.

The CPI, by comparison, has fixed weights that would not immediately adapt to that substitution.

Any other differences?

The indexes have differing approaches to some specific categories.

For example, the PCE looks at the price of medical care as the total of what the consumer and that consumer’s insurance company pays. By comparison, the CPI looks only at the out-of-pocket expense to the consumer.

Airfares are also measured differently between the two. PCE looks at the cost of flying based on the number of miles traveled by a passenger. CPI, however, compares prices for sampled routes.

Which one is better?

One isn’t necessarily better than the other. The differences are slight; mapping CPI against the PCE shows similar trends, although CPI tends to have higher readings than PCE.

The Federal Reserve prefers to use PCE because of its approach to substitutions. The central bank also likes PCE because the BLS sometimes updates and revises past data to account for new information and improved measurement techniques.

The Fed specifically looks at “core” PCE, which is a version of the index that removes the prices of food and energy. The reason: food and energy prices tend to be more volatile. For a central bank that is targeting stable prices over time, dramatic but temporary readings on inflation (i.e. from a storm that affects crop prices or a political standoff that affects gas prices) could mislead the Fed on what do with policy.

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