Long Term Perspective

One of the Fed’s two mandates is to maintain price stability. Therefore, inflation is always a key indicator among Fed officials. The consumer price index (CPI) is the most common inflation measure, but Federal Reserve officials prefer the personal consumption expenditure (PCE) price index. Fed officials believe the latter is more representative of changes in the actual cost-of-living. In order to remove inherent volatility in the price index coming from energy and food prices, these items are excluded and the resulting index (whether the CPI or the PCE price index) is called the “core” inflation rate.

It is important to remember that the PCE price index incorporates most of the CPI components. Nonetheless, it often shows less inflation than the CPI because it takes into account the fact that consumers tend to substitute lower priced goods for higher priced goods as relative prices change. The CPI measures a fixed basket of goods and services, and doesn’t allow for substitutions, thereby often overestimating actual prices paid by consumers in their purchases.

The widening and narrowing of the gap between the core CPI and the core PCE price index reveals shifts in the composition of goods and services actually purchased by consumers. Over the 10-year time horizon depicted in the chart, it is more likely than not to see a wide discrepancy between the core CPI and the core PCE price index. In the past few years, however, year-over-year changes in the two measures have been very similar although in mid-2006 the core CPI resumed the more typical higher inflation rate than that for the core PCE price index.

Short Term Perspective

In 2002, the Bureau of Labor Statistics (BLS) introduced an alternative measure of the consumer price index, called the Chained CPI. It differs from the regular CPI in that it is not a fixed basket of goods, but one that changes over time, akin to the PCE price index. In February 2004, Alan Greenspan, then chairman of the Federal Reserve, noted in Congressional testimony that this index more accurately reflects changes in the cost-of-living than the regular CPI. Since historical data is only available to 2000, the BLS cannot adjust this index for seasonal variation yet.

The chart depicts the year-over-year change in the core inflation rate of the CPI, the chained CPI, and PCE price index. Notice that the yearly changes in the chained CPI (C-CPI-U) are more similar to those of the PCE price index than the CPI.

Oddly enough, the PCE price index posted a higher inflation rate in 2004 than the either the regular CPI or the chained CPI. This means that consumers were purchasing more higher-priced items than suggested by a fixed weight index such as the CPI. During 2005 and in early 2006, the highest inflation rate was offered by the regular CPI, the lowest inflation rate by the chained CPI, and the PCE price index was somewhere in the middle. Since June of 2006, the traditional pattern has reemerged with CPI inflation the highest, PCE inflation the lowest, and chain CPI inflation in between. Getting the long-term trend down does take time and the Fed’s tight monetary policy in 2006 and into 2007 is paying off.

As of October, the core CPI on a year-on-year basis was unchanged at 2.1 percent from the month before but has it eased from a recent high of 2.8 percent for October 2006. The chained CPI was unchanged at 1.9 percent in October from September but is down from a recent high of 2.6 percent most recently seen in September 2006. The later released core PCE price index stood at 1.9 percent in October and compares to the recent high of 2.5 percent for February 2007. All three indexes are within the “acceptable” Fed range of 1 to 2 percent for the core PCE price index, once one takes into account the fact that the CPI tends to run about 1/4 percentage point higher than the PCE price index due to mere differences in the construction of the indexes.

On a monthly basis, the core CPI rose 0.2 percent in October, the same as in the prior four months. The core PCE price index rose 0.2 percent in October following a rise of the same magnitude the month before. The core chain CPI is not yet available on a seasonally adjusted basis.