Long Term Perspective

One of the Fed's two mandates is to maintain price stability which makes inflation indicators central to policy. 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 for 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 does not allow for substitutions, thereby typically overestimating actual prices paid by consumers in their purchases.

 

During early 2009, the CPI fell more than the PCE price index, likely due to the CPI having higher weights for gasoline and heating oil than the PCE index. It then grew faster than the PCE price index for the same reason during latter 2009. The two were at similar growth rates in 2010 and into early 2011. The CPI then outpaced the PCE price index during the second half of 2011 and into mid-2014 before the plunge in oil prices, when WTI fell roughly in half to $50 by early 2015, once again made for an outsized dip in the CPI relative to the PCE which extended through the whole of 2015.

 

 

The widening and narrowing of the gap between the core CPI and the core PCE price index also reveals shifts in the composition of goods and services actually purchased by consumers. Over the 11-year time horizon depicted in the chart, there are notable gaps between the CPI and the PCE price index. Over the long run, core CPI inflation averages about three-tenths to four-tenths of a percentage point higher than for the core PCE. Another factor at play is the fact that PCE component weights are updated each year while those for the CPI are updated only about every 10 years.

 

 

Short Term Perspective

In late 2009 and early 2010, various Fed officials indicated that they should not just be concerned about "core" inflation – which excludes food and energy – but overall inflation also. The chart below depicts the year-over-year change in the headline inflation rate of the CPI and PCE price index. Headline inflation rose sharply over the second half of 2007 and into mid-2008. During the second half of 2008 and into 2009, inflation eased sharply due to lower oil prices and the recession cutting into demand.  After a bump up during latter 2009 and early 2010, oil and energy costs eased during mid-2010 but firmed again in late 2010 and early 2011. Energy rose significantly in mid-2013. An easing in shelter cost inflation weighed on overall numbers in 2010 but rose in 2011 and into mid-2014. Headline inflation then slowed in the second half of 2014 and into the first half of 2015 on lower energy costs resulting from lower oil prices. As of fourth quarter 2015, both the CPI and PCE price indexes were tracking at only fractional year-on-year gains.

 

 

Turning to inflation excluding food and energy, the core CPI on a year-on-year basis was tracking right at 2 percent at year-end 2015 with, however, the PCE core index lower, tracking just under 1.5 percent.

 

 

Month-to-month, the CPI was unchanged in November as gasoline prices once again moved sharply lower. But the core CPI came in at plus 0.2 percent, as declines in transportation and apparel were offset by rising costs for medical care and incremental increases for housing.

 

 

The PCE price index rose a month-to-month 0.1 percent in October with the core rate unchanged. The trajectory for this report, in contrast to the CPI, was not moving higher.