WHAT IS PCE? EXPLAINING THE FED'S PREFERRED INFLATION MEASURE

The following information was released by the Federal Reserve Bank of Atlanta:

For the past quarter-century, the Federal Reserve has preferred one price measure for consumer spending, that big segment of the economy the Fed considers in its efforts to promote its two congressionally mandated economic goals of stable prices and maximum employment.

The Fed uses the personal consumption expenditures price index (PCE), produced monthly by the US Bureau of Economic Analysis (BEA), in deciding where to set an important interest rate, the fed funds rate. The fed funds rate influences the interest rate that credit card companies and other lenders charge consumers. The rates on these short-term loans affect consumer spending, which is a contributing factor to the rate of inflation. Expectations of future values of the fed funds rate can also influence mortgage and longer-term interest rates.

PCE versus CPI

Previously, the Fed had used the consumer price index (CPI) as its preferred tool to measure consumer prices. The CPI is released each month by the US Bureau of Labor Statistics, although with spending weights updated annually on subindices such as telephone services and automobiles. Despite the lag in data, the CPI remains among the most widely known economic statistics for the general public in the United States and is used to adjust the amount of many forms of payments, such as those for government programs including Social Security benefits. The media frequently cite the CPI in reports on the posture of the nation's economy. And many of the item-level PCE prices, such as most food and apparel categories, come directly from the CPI database.

Some central banks in other countries rely on their CPI measures that resemble the US measure to help them evaluate inflation trends in their economies, according to Pat Higgins, the Atlanta Fed economist who created the popular GDPNow forecasting model. The most widely used estimation method for GDP measures it as the sum of consumption, investment and several other expenditures. Most countries report consumer expenditures with other GDP-related statistics on a quarterly or annual basis. The United States is one of the few countries with an aggregate monthly consumption measure.

Why the Fed changed its preferred inflation measure

The Fed moved away from the CPI informally around 2000 and officially adopteda longer-run target of 2 percent for PCE inflation beginning in 2012. The shift from CPI to PCE was announced in February 2000, as part of then Fed chair Alan Greenspan's routine testimony to Congress. Greenspan presented a report that contained a footnote remarking on the shift to PCE from CPI and noting that other price measures would continue to be observed. The footnote observed that the formulas in the PCE produce an economic indicator that is "a more consistent series over time" than the CPI.

Greenspan had previously cited concerns with the use of the CPI. In comments during a July 1996 meeting of the policy-setting Federal Open Market Committee, Greenspan said the PCE is "the best consumer price index by far," and "the emphasis that we have been putting on the Consumer Price Index, I think in retrospect, is turning out to have been a mistake."

Why the Fed uses PCE over CPI

The two indices provide different perspectives on the economy because of differences in their data formulas. The Cleveland Fed reports that three factors in the formulas account for the CPI tending to report a higher inflation rate than the PCE. One example is the PCE updates its expenditure weights used to combine prices every month, whereas the CPI weights are updated annually. This more frequent updating results in the PCE inflation rate being lower than the CPI rate because PCE can capture and calculate a consumer shift to cheaper options as prices rise, such as substituting a cheaper meat for steak.

Higgins elaborated on distinctions between the two price measures. "The consumer spending measure associated with the CPIcalled the Consumer Expenditure Surveyis only released once a year or so for benchmarking and weight calculations," Higgins said. "Retail sales, an important monthly economic report released by the Census Bureau, is one of several pieces of data that BEA uses to measure the dollar amounts for personal consumption expenditures on most goods categories. That release was used in the calculations even before the 1990s."

In 2012, the Fed named the PCE as its preferred yardstick for measuring inflation. This was part of the Fed's new commitment to an annual inflation target of 2 percent. The Fed has reaffirmed its commitment to the PCE and 2 percent target every year since 2012, most recently in January, in its document known as Statement on Longer-Run Goals and Monetary Policy Strategy.

The longevity of the Fed's use of the PCE price measure speaks to the Fed's high degree of confidence in the tool. The Fed has relied on the PCE through three US financial crises: the recession spurred by the 2001 bursting of the dot-com bubble and the attacks of September 11, the Global Financial Crisis of 2007 to 2009, and the COVID-19 recession of 2020.

As the Cleveland Fed noted in its report on the two primary measurements of the cost of living, the CPI and the PCE: "The PCE price index offers a broader and more comprehensive measure of inflation and more quickly picks up adjustments in consumers' choices in response to price changes." The Federal Reserve observes the "PCE index is constructed in a way that accounts for how Americans are spending their money at a given time and more quickly adapts to changes in spending patterns."