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Infocus - With the Federal Reserve facing the difficult issue of deciding when to reduce bond purchases, investors have followed US inflation developments closely in recent months. In this issue of Infocus, EFG chief economist Stefan Gerlach compares the two main measures of US inflation.
With the Federal Reserve facing the difficult issue of deciding when to reduce bond purchases, investors have followed US inflation developments closely in recent months. In this issue of Infocus, EFG chief economist Stefan Gerlach compares the two main measures of US inflation.
With the likelihood and timing of any Fed decision to taper bond purchases depending in part on the outlook for inflation, investors have followed US price developments closely in recent months. The central issue from the Fed’s perspective is whether the recent increase in inflation will require a tightening of monetary policy to return it towards the 2% level or if it will do so on its own. Investors are keenly watching for any evidence that inflation pressures are abating.
The behaviour of CPI and PCE inflation
In doing so they are helped by the fact that the US authorities publish two indices that can be used to measure inflation. The first of these is the Consumer Price Index, CPI, which is published by the Bureau of Labor Statistics.1 The second price index is the deflator for Personal Consumption Expenditures, PCE, which is published by the Bureau of Economic Analysis.2
As Figure 1 shows, inflation computed using these two price indices behaves somewhat differently. While it is sensible for market analysts to look at both measures, it is important to be aware of the differences and why they arise.
1. Annual inflation in the US
Figure 2, which contains the mean and standard deviation of inflation over 12 months over the period January 2001 – June 2021, shows that CPI inflation has on average been a little higher and more volatile than PCE inflation.
2. Inflation over 12 months, Jan 2001 – June 2021
To get a better sense of these differences, Figure 3 shows a scatter plot of CPI and PCE inflation.
3. Annual CPI and PCE inflation
There is an almost perfect relationship between the two variables, as evidenced by a correlation coefficient of 0.98. A fitted line through the data shows that PCE inflation can be thought of as being about 0.8 times CPI inflation. This implies that CPI inflation is above PCE inflation when inflation is positive, but below PCE inflation when inflation is negative. Overall, PCE inflation varies less than CPI inflation.
Which measure is more important?
Whether observers should focus on PCE or CPI inflation depends on the nature of the interest in inflation. If it arises from a concern about the outlook for monetary policy, however, then the answer is clear: PCE inflation is more important than CPI inflation.3
1See https://www.bls.gov/cpi/
2See https://www.bea.gov/data/personal-consumption-expenditures-price-index
3In contrast, the CPI is used to adjust social security payments and is also a reference rate for some financial contracts.
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