CPI vs PCE: The Differences and the Importance of It

CPI vs PCE: The Differences and the Importance of It

Reading time: 8 minutes

Following a peak in inflation of 9.1% in June 2022, the US economy (and most major G10 economies) is in a disinflationary process in 2024. As a result, with inflation data still being the main concern for many central banks, inflation reports continue to draw worldwide attention. Consequently, there has never been a better time to understand how inflation is measured in the US, the largest economy in the world according to Gross Domestic Product (GDP). 

To help assess the prices paid for goods and services by consumers, economists rely on two primary measures to gauge inflation: the Consumer Prices Index (CPI) released by the Bureau of Labor Statistics (BLS) and the Personal Consumption Expenditures Price Index (PCE) prepared by the Bureau of Economic Analysis (BEA). Understanding these measures and their differences is crucial for anyone interested in the practical implications of inflation on the economy. 

What is Inflation?

Think of inflation as a time machine that devalues your money. A dollar today won't buy you as much as it did thirty years ago or even five years ago. This is because the cost of goods and services has risen over time, and this overall increase is what we call inflation. 

Another important definition to understand is ‘disinflation’, a term used regularly in financial media. All this means is that while the prices of goods and services are still rising, they are doing so at a slower pace. For example, inflation was 4.0% in February 2019, but in February 2020, inflation was 3.2%; inflation is still rising but at a slower rate on a year-on-year basis. You may have also heard of ‘deflation’, a term essentially meaning that the prices of goods and services are negative (falling). 

Headline Versus Core Inflation?

Financial media often refer to headline inflation (nominal) data and core inflation data, which are imperative to understand. The former includes all goods and services listed within the chosen index, while core inflation excludes food and energy prices to attempt to control for an economy's more volatile components. Removing these elements filters wilder fluctuations and makes it easier to define the trend in underlying inflation. 

The PCE Price Index and the CPI: The Basics

• The PCE Price Index, included within the Personal Income and Outlays report, measures prices paid by households in the US for a basket of final goods and services. These are goods and services purchased by consumers (both urban and rural) and produced in the US. The PCE Price Index does not include prices for goods and services purchased by businesses/wholesale, which is the development at earlier stages of the production process.
• The CPI is similar to the PCE Price Index in that its purpose is to provide economists with a single value for the change in the prices for the basket of goods and services consumed by urban consumers. Additionally, like the PCE Price Index, the CPI does not include wholesale prices paid.

PCE Inflation Versus CPI Inflation

Although both measures gauge prices based on a basket of goods and services, variances between the two releases must be understood. 

As illustrated in the chart below, which reflects the annual percentage changes for both the PCE Price Index and the CPI, you will acknowledge that the measures generally correlate with one another and the difference between the two is not significant. This means that, on average, they tend to move in unison. 

Which one is considered the more important measure? 

The CPI is the most widely watched measure of inflation in the US (this is true for many developed economies), but whether it should be is the question. Of relevance, the CPI measure is released nearly two weeks before the PCE Price Index, often moving Stocks, Currencies and Bonds. On the other hand, the PCE Price Index is the favoured measure of inflation by the Federal Open Market Committee (FOMC), which is the policy-making arm of the US Federal Reserve (Fed). 

Despite what many in the financial media say, the Fed does not use the core PCE Price Index for inflation targeting; it uses the headline PCE Price Index, which has been the case since early 2012. Interestingly, inflation targeting was not seen at Fed meetings until the late 1990s. 

The Fed began explicit inflation targeting in 2012, noting the following regarding this:

‘The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate’.

Which index covers a broader scope of goods and services?

The PCE Price Index includes both urban and rural expenditures, whereas the CPI only covers urban expenditures. 

While the price data used to form the PCE Price Index is derived from a large part of the CPI data, the PCE covers a far broader choice of goods and services, referred to as the ‘scope effect’. A clear example of this can be found in medical care services. Within the PCE Price Index, healthcare services are allocated a far greater weighting than the CPI. In the PCE, medical care services include not only goods and services purchased by household consumers but also those purchased on behalf of consumers (including healthcare services provided by employers and government-funded programmes, like Medicare). For the CPI, data are derived from prices paid only by household consumers.

How do the weights between the two inflation measures differ?

The expenditure weights for the PCE are variable and change to suit expenditure habits, helping to mitigate ‘substitution bias’. Importantly, the PCE Price Index is a chain-type index that reflects any change in consumer spending patterns earlier than the fixed-weight CPI method. The CPI is updated annually, which explains why it tends to be higher than the PCE Price Index most of the time. The CPI basket will continue to focus on more expensive goods and services, despite some consumers purchasing more economical goods and services when prices increase, which are reflected in the PCE Price Index. 

Another important note is that the CPI and the PCE Price Index use different sources to apply weights to their consumption categories. The CPI applies weights through household surveys derived from Consumer Expenditure Surveys (CE), while the PCE Price Index employs the National Income and Product (NIPA), which has its data derived from businesses. This will account for some of the differences between the two inflation indexes and is sometimes referred to as the ‘weight effect’. 

Are the calculations of the two indexes the same?

While both the PCE and CPI are released monthly, and both track changes in the cost of living for households within the economy, the formulas used to establish the indexes are different. The CPI employs what is known as a modified Laspeyres formula; the PCE Price Index, however, uses a Fischer-Ideal Formula.