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How is inflation measured: Yahoo U

Yahoo Finance's Brian Cheung talks about different measurements of inflation.

Video transcript

ZACK GUZMAN: Welcome back to Yahoo Finance Live. Inflation fears have been the talk of the town this week after fears of rising inflation sent stocks tumbling earlier this week when the Labor Department gave us our update that showed the biggest spike in consumer prices month over month since 2009. But what does that mean and how does it differ from the way that the Fed gauges inflation?

Here to break that down for us in this week's Yahoo U is Yahoo Finance's Professor Brian Cheung. Brian?

BRIAN CHEUNG: Hey, Zack. Well, class is in session. As you mentioned, we got a CPI print on Wednesday that had a lot of people talking about inflation. Actually, it was trending on Google Trends that many people are interested in it. But the thing is you get that magical number without knowing exactly what's underlying it. And the problem is that there are many ways to measure inflations, many ways to skin the cat, if you will. And tracking inflation means tracking the prices of a bunch of stuff.

So as you look at the kind of graphic ahead of you, think about a basket of goods, right? Tracking prices that consumers pay for goods and services. So some prices will go up. Maybe a price of a can of beer or a TV. Prices will go down as well. But the question is how you calculate those things in the aggregate where you get total price inflation as the basket. Should certain categories be weighed more than others?

And that's what distinguishes the two major measures of inflation. So, personal consumption expenditures and then consumer price index. And by the way CPI is the one that we got on Wednesday. So what differentiates these two things? Well, let's take a look at CPI first.

So again, let's go back to this idea of a basket of goods. So, this is going to use different weights than the other measures. So it may weigh-- and I'm just making this up-- let's say TVs or sneakers more than the PCE. So if prices in these two categories rocket up, that might affect the headline CPI inflation rate more than it would in other inflation measures.

But there's also really interesting, unique nuances. And this is not hypothetical. This is truly part of the CPI. Think about air fare, right? The CPI is going to look at a sample route and say, has the price changed for the same fare from, let's say, JFK to LAX? Whereas the PCE, by comparison-- so again, looking at a different basket -- If you're looking at airline prices, the way that they measure that is by the amount that a consumer paid for the mileage that they traveled. So 500 miles, if you will. It's not looking at the same route from point A to point B.

There's also the difference of healthcare costs. So very interestingly, insurance covers a lot but not all the cost of getting, let's say, a cavity fixed as your boy found out earlier this week. PCE is going to measure the cost as the total bill, so whatever you paid in addition to the big chunk that the insurance company paid. But CPI, that only measures the out-of-pocket costs to the consumer. So whatever your copay was, for example.

But the most important distinction for PCE is actually substitution. So let's say for example, all of a sudden people start buying fewer bicycles because maybe they're driving more. They're buying more cars, right? The formula for PCE is going to adjust to account for that different weighting, because fewer people are buying bikes.

Now the prices, or rather the differences between these price measures are pretty minor, right? So CPI is in purple. PCE is in blue. You can see that they track each other relatively closely. But CPI does generally have higher readings on inflation. The purple line tends to be above the blue line. And that spike in the purple line that you saw was the April reading that we got on Wednesday.

But one important thing to note here is that both of these indexes that I'm showing you on this screen, going back to, let's say, 2010, include food and energy. And those tend to be more volatile, right? You think about bad weather. That can make crop prices a little crazy. We saw with the colonial pipeline story over the last week that gas prices can be a little bit all over the place, too. And that's why for policymakers like the Federal Reserve, the central bank, they prefer PCE but with a twist, stripping out food and energy.

And this is the so-called core PCE inflation reading. So I'm showing you the last 50 plus years of core PCE, and you'll see the historical account of double digit inflation in the 1970s, right? Something that nobody wants to remember. But the story now is very different, right? Inflation's been low. And that's despite the concern after the financial crisis that the amount of printing that the Fed was going to do was maybe going to lead to inflation rocketing back up. You can see that that hasn't really happened since that point in time.

But nonetheless, people are still talking a lot about inflation right now. We've got trillions of in fiscal stimulus. The Fed's balance sheet is getting close to $8 trillion. People are wondering, how could inflation not go up? And there's a lot of structural factors at play here, which is why people will be very dialed into more PCE, CPI readings in the coming months. But at least now, our Yahoo U students will know a little bit more about what differentiates those two measures.

And with that, class is dismissed.

- A very timely class, we should say, Brian, with all the jitters in the market right now. Thanks so much for.