In the United States, inflation is measured by two main indicators: the Consumer Price Index (CPI), published by the Bureau of Labor Statistics (BLS), and the Personal Consumption Expenditures Price Index (PCE), produced by the Bureau of Economic Analysis (BEA). U.S. policymakers monitor both indices. The PCE is particularly known as the "Fed's preferred index," while the CPI is used by the government to adjust payments.

Both indices reflect changes in prices paid by consumers for goods and services, but they have different calculation methods and scopes. As a result, they often show different inflation results for the same period. The main reasons for the differences between these two indices include:

Scope Effect

The most significant difference between the two indices is their scope, which creates a multiplier effect on other differences. The CPI takes a narrower approach to consumer spending, measuring only the changes in urban consumer spending made directly out of their own pockets. On the other hand, the PCE includes both urban and rural consumer spending made out of pocket, as well as expenditures made on behalf of households by other third parties. PCE also includes expenditures by non-profit institutions. Thus, some expenditures included in the PCE scope are outside the CPI scope.

For example, CPI only covers medical services purchased out-of-pocket by households. In contrast, the PCE index considers medical services both purchased by consumers and on behalf of consumers. For instance, medical services purchased through employer or government-provided health insurance are included in the PCE index but not in the CPI.

Formulation Effect

Another reason why the two indices produce different results is their use of different formulations. While the PCE index's formulation accounts for substitution effects, CPI does not. PCE's formula better captures that consumers substitute products based on relative prices, such as switching from beef to chicken if beef prices rise. The inability of CPI to reflect substitution effects is traditionally seen as one reason why CPI tends to be higher.

On the other hand, the weights of the basket of goods and services used to measure price changes over time in CPI are updated annually. Thus, CPI is thought not to fully reflect consumer habits. PCE uses a broader basket and also updates the weights of goods and services in the basket every three months. Therefore, PCE can reflect changes in consumer preferences more quickly.

Weighting Effect

Both indices use different data sources to calculate the relative share of each consumption item. The weights used in CPI are based on the Consumer Expenditure Survey, a household survey conducted by the Census Bureau for the BLS. The relative weights used in the PCE index are derived from business surveys, including the Census Bureau's annual and monthly retail trade surveys, the Annual Services Survey, and the Quarterly Services Survey.

On the other hand, PCE typically assigns lower weights to housing and energy items than CPI. For example, housing constitutes 32.9% of the CPI basket but only 15.9% of the PCE basket. This can lead to noticeable differences between the two indices.

Conclusion

Both indices are important indicators reflecting the state of the U.S. economy and are integral parts of the policymaking process. Understanding the differences between them is crucial for interpreting the potential impacts of reported data and assessing market opportunities.