PCE Inflation, How It's Calculated and Why the Fed Prefers It
Why the Fed Worries About Inflation
The PCE inflation rate is the Personal Consumption Expenditures Price Index. It measures price changes for household goods and services. In January 2018, prices had risen 1.7 percent in the past year, according to the Personal Income and Outlays Report.
Core PCE Inflation
The commodities markets determine oil prices, which then affects gas and then food prices. When traders expect oil supply or demand will change, they speculate on oil prices. The strength of the dollar also affects oil prices. The core PCE price index removes that volatility and gives an accurate picture of real inflation. It reports on all types of inflation.
How It's Calculated
The Bureau of Economic Analysis estimates the PCE price index each month. It uses the same data that creates the quarterly gross domestic product report. But this report measures production, and the PCE price index measures consumer purchases. How does the BEA convert the GDP report to the PCE price index?
First, the BEA estimates how much is being consumed based on the GDP data from suppliers.
That includes manufacturers’ shipments, revenue for utilities, service receipts, and commissions for securities brokerage. Next, it adds imports. It then subtracts exports and changes in inventory to determine the amount available for domestic consumption. The BEA allocates the result among domestic purchasers.
It bases this on trade source data, Census data, and household income surveys.
The last step involves converting the prices, which are still the producers' prices, to the end price paid by the consumer. The BEA bases the prices on the Consumer Price Index. The PCE price index includes estimates from other price sources. It adds the cost of profit margins, taxes, and transportation costs. That makes it a little more broadly based. The BEA includes data from the Census Bureau’s Economic Censuses, International Transactions Accounts, and various government agencies. For example, the price for food that is grown and eaten on the farm are derived from the USDA. The dealer's margin for used cars and trucks is taken directly from the National Auto Dealers Association.
Since the GDP report is quarterly, and the PCE price index is estimated monthly, the BEA must estimate even further to fill in the gap. It does this using the monthly retail sales report. Also, the BEA updates all its calculations using data from the U.S. Population Census every 10 years. (Source: "Methodology Papers," NIPA Handbook: Concepts and Methods of the U.S. National Income and Product Accounts, Chapter 5: Personal Consumption Expenditures, Bureau of Economic Analysis.)
PCE Price Index Versus CPI
The PCE price index is the lesser-known inflation measure. More people are familiar with the Consumer Price Index. What's the difference? The PCE index uses data from the GDP report and businesses. The CPI is taken from household surveys made by the Bureau of Labor Statistics. It surveys 14,500 families and the 23,000 businesses they frequent. The BLS collects prices for 80,000 consumer items. The CPI includes sales taxes, but not income taxes. For more on the CPI survey, go to the BLS website.
The PCE price index collects data on some different types of goods and services than the CPI does. For example, the PCE price index counts health care services paid for by employer-sponsored health insurance Medicare and Medicaid. The CPI only counts medical services paid for directly by consumers.
Second, the PCE price index and the CPI use different types of formulas to calculate price changes. The CPI formula is more likely to report wide price swings in gasoline. The PCE calculations smooth out these price swings. That makes the PCE less volatile than the CPI. (Source: Jill Mislinski, "Two Measures of Inflation: A New Update," Advisor Perspectives, August 29, 2016.)
The Fed's Preferred Measure of Inflation
In January 2012, the Federal Reserve stated at its monthly FOMC meeting that it would use the core PCE price index as its primary measure of inflation. If the core inflation rate is above the Fed's 2 percent target inflation rate for an extended period, then the Fed will take action to prevent inflation. Its first line of defense is raising the fed funds rate, but it does have many other tools. The Fed uses the core inflation rate because food, oil and gas prices move so rapidly, especially in the spring and summer, and the Fed's tools take a long time to act.
Why the Core PCE Price Index Was Redefined
In July 2009, the BEA redefined what was included in the core PCE price index. It now includes prices for restaurant meals and pet food. Even though these are still food items, the BEA reclassified restaurant meals under food services and pet food under pets. The BEA considers the prices of restaurant meals and pet food to be less volatile than grocery store food prices. That's particularly true for fresh vegetables that have to be trucked great distances and so vary with the price of oil and gas. The changing prices of pet food and restaurant meals are still reflective of real underlying inflation trends.