CPI inflation v. PCE inflation – HubbardOBrienEconomics.com Blog

Is Sugar All You Need?

Dylan’s Candy Bar in New York City (Photo from the New York Times)

Can prices of one type of good track inflation accurately? As we’ve discussed in a number of blog posts (for instance, here, here, and here), there is a debate among economists about which of the data series on the price level does the best job of tracking the underlying rate of inflation.

The most familiar data series on the price level is the consumer price index (CPI). Core CPI excludes the—typically volatile—food and energy prices. In gauging whether it is achieving its goal of 2 percent annual inflation, the Federal Reserve uses the personal consumption expenditures (PCE) price index. The PCE price index includes the prices of all the goods and services included in the consumption category of GDP, which makes it a broader measure of inflation than the CPI. To understand the underlying rate of inflation, the Fed often focuses on movements in core PCE.

With the increase in inflation that started in the spring of 2021, some economists noted that the prices of particular goods and services—such as new and used cars and housing—were increasing much more rapidly than other prices. So some economists concentrated on calculating inflation rates that excluded these or other prices from either the CPI or the PCE.

For example, the following figure shows the inflation rate measured by the percentage change from the same month in the previous year using the median CPI and using the trimmed mean PCE. If we list the inflation rate in each individual good or service in the CPI, median inflation is the inflation rate of the good or service that is in the middle of the list—that is, the inflation rate in the price of the good or service that has an equal number of higher and lower inflation rates. The trimmed mean measure of PCE inflation is compiled by economists at the Federal Reserve Bank of Dallas by dropping from the PCE the goods and services that have the highest and lowest rates of inflation. During the period when the inflation rate was increasing rapidly during 2021 and 2022, CPI inflation increased more and was more volatile than PCE inflation. That difference between movements in the two price level series is heightened when comparing median inflation in the CPI with trimmed mean inflation in the PCE. In particular, using trimmed mean PCE, the inflation of late 2021 and 2022 seems significantly milder than it does using median CPI.

The United States last experienced high inflation rates in the 1970s, when few people used personal computers and easily downloading macroeconomic data from the internet wasn’t yet possible. Today, it’s comparatively easy to download data on the CPI and PCE and manipulate them to investigate how the inflation rate would be affected by dropping the prices of various goods and services. It’s not clear, though, that this approach is always helpful in determining the underlying inflation rate. In a market system, the prices of many goods and services will be affected in a given month by shifts in demand and supply that aren’t related to general macroeconomic conditions.

In a recent blog post, economists B. Ravikumar and Amy Smaldone of the Federal Reserve Bank of St. Louis note that there is a strong correlation between movements in the prices of the “Sugar and Sweets” component of the CPI and movements in the overall CPI. Their post includes the following two figures. The first shows the price level since 1947 calculated using the prices of all the goods and services in the CPI (blue line) and the price level calculated just using the prices of goods included in the “Sugar and Sweets” category (red line). The data are adjusted to an index where the value for each series in January 1990 equals 100. The second figure shows the percentage change from the previous month for both series for the months since January 2000.

The two figures show an interesting—and perhaps surprising—correlation between sugar and sweets prices and all prices included in the CPI. The St. Louis Fed economists note that although the CPI is only published once per month, prices on sugar and sweets are available weekly. Does that mean that we could use prices on sugar and sweets to predict the CPI? That seems unlikely. First, consider that the sugar and sweets category of the CPI consists of three sub-categories:

White, brown, and raw sugar and natural and artificial sweetners
Chocolate and other types of candy, fruit flavored rolls, chewing gum and breath mints
Other sweets, including jelly and jams, honey, pancake syrup, marshmallows, and chocolate syrup

Taken together these products are less than 3 percent of the products included in the CPI. In addition, the prices of the goods in this category can be heavily dependent on movements in sugar and cocoa prices, which are determined in world wide markets. For instance, the following figure shows the world price of raw cocoa, which soared in 2024 due to bad weather in West Africa, where most cocoa is grown. There’s no particular reason to think that factors affecting the markets for sugar and cocoa will also affect the markets in the United States for automobiles, gasoline, furniture, or most other products.

In fact, as the first figure below shows, if we look at the inflation rate calculated as the percentage change from the same month in the previous year, movements in sugar and sweets prices don’t track very closely movements in the overall CPI. Beginning in the summer of 2022—an important period when the inflation that began in the spring of 2021 peaked—inflation in sugar and sweets was much higher than overall CPI inflation. Anyone using prices of sugar and sweets to forecast what was happening to overal CPI inflation would have made very poor predictions. We get the same conclusion from comparing inflation calculated by compounding the current month’s rate over an entire year: Inflation in sugar and sweets prices is much more volatile than is overall CPI inflation. That conclusion is unsurprising given that food prices are generally more volatile than are the prices of most other goods.

It can be interesting to experiment with excluding various prices from the CPI or the PCE or with focusing on subcategories of these series. But it’s not clear at this point whether any of these adjustments to the CPI and the PCE, apart from excluding all food and energy prices, gives an improved estimate of the underlying rate of inflation.

Key Macro Data Series during the Time Since the Arrival of Covid–19 in the United States

A bookstore in New York City closed during Covid. (Photo from the New York Times)

Four years ago, in mid-March 2020, Covid–19 began to significantly affect the U.S. economy, with hospitalizations rising and many state and local governments closing schools and some businesses. In this blog post we review what’s happened to key macro variables during the past four years. Each monthly series starts in February 2020 and the quarterly series start in the fourth quarter of 2019.

Production

Real GDP declined by 5.8 percent from the fourth quarter of 2019 to the first quarter of 2020 and by an additional 28.0 percent from the first quarter of 2020 to the second quarter. This decline was by far the largest in such a short period in the history of the United States. From the second quarter to the third quarter of 2020, as businesses began to reopen, real GDP increased by 34.8 percent, which was by far the largest increase in a single quarter in U.S. history.

Industrial production followed a similar—although less dramatic—path to real GDP, declining by 16.8 percent from February 2020 to April 2020 before increasing by 12.3 percent from April 2020 to June 2020. Industrial production did not regain its February 2020 level until March 2022. The swings in industrial production were smaller than the swings in GDP because industrial production doesn’t include the output of the service sector, which includes firms like restaurants, movie theaters, and gyms that were largely shutdown in some areas. (Industrial production measures the real output of the U.S. manufacturing, mining, and electric and gas utilities industries. The data are issued by the Federal Reserve and discussed here.)

Employment

Nonfarm payroll employment, collected by the Bureau of Labor Statistics (BLS) in its establishment survey, followed a path very similar to the path of production. Between February and April 2020, employment declined by an astouding 22 million workers, or by 14.4 percent. This decline was by far the largest in U.S. history over such a short period. Employment increased rapidly beginning in April but didn’t regain its February 2020 level until June 2022.

The employment-population ratio measures the percentage of the working-age population that is employed. It provides a more comprehensive measure of an economy’s utilization of available labor than does the total number of people employed. In the following figure, the blue line shows the employment-population ratio for the whole working-age population and the red line shows the employment-population ratio for “prime age workers,” those aged 25 to 54.

For both groups, the employment-population ratio plunged as a result of Covid and then slowly recovered as the production began increasing after April 2020. The employment-population ratio for prime age workers didn’t regain its February 2020 value until February 2023, an indication of how long it took the labor market to fully overcome the effects of the pandemic. As of February 2024, the employment-population ratio for all people of working age hasn’t returned to its February 2020 value, largely because of the aging of the U.S. population.

Average weekly hours worked followed an unusual pattern, declining during March 2020 but then increasing to beyond its February 2020 level to a peak in April 2021. This increase reflects firms attempting to deal with a shortage of workers by increasing the hours of those people they were able to hire. By April 2023, average weekly hours worked had returned to its February 2020 level.

Income

Real average hourly earnings surged by more than six percent between February and April 2020—a very large increase over a two-month period. But some of the increase represented a composition effect—as workers with lower incomes in services industries such as restaurants were more likely to be out of work during this period—rather than an actual increase in the real wages received by people employed during both months. (Real average hourly earnings are calculated by dividing nominal average hourly earnings by the consumer price index (CPI) and multiplying by 100.)

Median weekly real earnings, because it is calculated as a median rather than as an average (or mean), is less subject to composition effects than is real average hourly earnings. Median weekly real earnings increased sharply between February and April of 2020 before declining through June 2022. Earnings then gradually increased. In February 2024 they were 2.5 percent higher than in February 2020.

Inflation

The inflation rate most commonly mentioned in media reports is the percentage change in the CPI from the same month in the previous year. The following figure shows that inflation declined from February to May 2020. Inflation then began to rise slowly before rising rapidly beginning in the spring of 2021, reaching a peak in June 2022 at 9.0 percent. That inflation rate was the highest since November 1981. Inflation then declined steadily through June 2023. Since that time it has fluctuated while remaining above 3 percent.

As we discuss in Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5), the Federal Reserve gauges its success in meeting its goal of an inflation rate of 2 percent using the personal consumption expenditures (PCE) price index. The following figure shows that PCE inflation followed roughly the same path as CPI inflation, although it reached a lower peak and had declined below 3 percent by November 2023. (A more detailed discussion of recent inflation data can be found in this post and in this post.)

Monetary Policy

The following figure shows the effective federal funds rate, which is the rate—nearly always within the upper and lower bounds of the Fed’s target range—that prevails during a particular period in the federal funds market. In March 2020, the Fed cut its target range to 0 to 0.25 percent in response to the economic disruptions caused by the pandemic. It kept the target unchanged until March 2022 despite the sharp increase in inflation that had begun a year earlier. The members of the Federal Reserve’s Federal Open Market Committee (FOMC) had initially hoped that the surge in inflation was largely caused by disuptions to supply chains and would be transitory, falling as supply chains returned to normal. Beginning in March 2022, the FOMC rapidly increased its target range in response to continuing high rates of inflation. The targer range reached 5.25 to 5.50 percent in July 2023 where it has remained through March 2024.

Although the money supply is no longer the focus of monetary policy, some economists have noted that the rate of growth in the M2 measure of the money supply increased very rapidly just before the inflation rate began to accelerate in the spring of 2021 and then declined—eventually becoming negative—during the period in which the inflation rate declined.

As we discuss in the new 9th edition of Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5), some economists believe that the FOMC should engage in nominal GDP targeting. They argue that this approach has the best chance of stabilizing the growth rate of real GDP while keeping the inflation rate close to the Fed’s 2 percent target. The following figure shows the economy experienced very high rates of inflation during the period when nominal GDP was increasing at an annual rate of greater than 10 percent and that inflation declined as the rate of nominal GDP growth declined toward 5 percent, which is closer to the growth rates seen during the 2000s. (This figure begins in the first quarter of 2000 to put the high growth rates in nominal GDP of 2021 and 2022 in context.)

Fiscal Policy

As we discuss in the new 9th edition of Macroeconomics, Chapter 15 (Economics, Chapter 25), in response to the Covid pandemic Congress and Presidents Trump and Biden implemented the largest discretionary fiscal policy actions in U.S. history. The resulting increases in spending are reflected in the two spikes in federal government expenditures shown in the following figure.

The initial fiscal policy actions resulted in an extraordinary increase in federal expenditures of $3.69 trillion, or 81.3 percent, from the first quarter to the second quarter of 2020. This was followed by an increase in federal expenditures of $2.31 trillion, or 39.4 percent, from the fourth quarter of 2020 to the first quarter of 2021. As we recount in the text, there was a lively debate among economists about whether these increases in spending were necessary to offest the negative economic effects of the pandemic or whether they were greater than what was needed and contributed substantially to the sharp increase in inflation that began in the spring of 2021.

Saving

As a result of the fiscal policy actions of 2020 and 2021, many households received checks from the federal government. In total, the federal government distributed about $80o billion directly to households. As the figure shows, one result was to markedly increase the personal saving rate—measured as personal saving as a percentage of disposable personal income—from 6.4 percent in December 2019 to 22.0 in April 2020. (The figure begins in January 2020 to put the size of the spike in the saving rate in perspective.)

The rise in the saving rate helped households maintain high levels of consumption spending, particularly on consumer durables such as automobiles. The first of the following figure shows real personal consumption expenditures and the second figure shows real personal consumption expenditures on durable goods.

Taken together, these data provide an overview of the momentous macroeconomic events of the past four years.

Consumer Price Inflation Comes in Somewhat Higher than Expected

Federal Reserve Chair Jerome Powell (Photo from Bloomberg News via the Wall Street Journal.)

Economists, policymakers, and Wall Street analysts have been waiting for macroeconomic data to confirm that the Federal Reserve has brought the U.S. economy in for a soft landing, with inflation arrving back at the Fed’s target of 2 percent without the economy slipping into a recession. Fed officials have been cautious about declaring that they have yet seen sufficient data to be sure that a soft landing has actually been achieved. Accordingly, they are not yet willing to begin cutting their target for the federal funds rate.

For instance, on March 6, in testifying before the Commitee on Financial Services of the U.S. House of Representatives, Fed Chair Jerome Powell stated that the Fed’s Federal Open Market Committee (FOMC) “does not expect that it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.” (Powell’s statement before his testimony can be found here.)

The BLS’s release today (March 12) of its report on the consumer price index (CPI) (found here) for February indicated that inflation was still running higher than the Fed’s target, reinforcing the cautious approach that Powell and other members of the FOMC have been taking. The increase in the CPI that includes the prices of all goods and services in the market basket—often called headline inflation—was 3.2 percent from the same month in 2023, up slightly from 3.1 In January. (We discuss how the BLS constructs the CPI in Macroeconomics, Chapter 9, Section 19.4, Economics, Chapter 19, Section 19.4, and Essentials of Economics, Chapter 3, Section 13.4.) As the following figure shows, core inflation—which excludes the prices of food and energy—was 3.8 percent, down slightly from 3.9 percent in January.

If we look at the 1-month inflation rate for headline and core inflation—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—the values are more concerning, as indicated in the following figure. Headline CPI inflation is 5.4 percent (up from 3.7 percent in January) and core CPI inflation is 4.4 percent (although that is down from 4.8 percent in January). The Fed’s inflation target is measured using the personal consumption expenditures (PCE) price index, not the CPI. But CPI inflation at these levels is not consistent with PCE inflation of only 2 percent.

Even more concerning is the path of inflation in the prices of services. As we’ve noted in earlier posts, Chair Powell has emphasized that as supply chain problems have gradually been resolved, inflation in the prices of goods has been rapidly declining. But inflaion in services hasn’t declined nearly as much. Last summer he stated the point this way:

“Part of the reason for the modest decline of nonhousing services inflation so far is that many of these services were less affected by global supply chain bottlenecks and are generally thought to be less interest sensitive than other sectors such as housing or durable goods. Production of these services is also relatively labor intensive, and the labor market remains tight. Given the size of this sector, some further progress here will be essential to restoring price stability.”

The following figure shows the 1-month inflation rate in services prices and in services prices not included including housing rent. Some economists believe that the rent component of the CPI isn’t well measured and can be volatile, so it’s worthwhile to look at inflation in service prices not including rent. The figure shows that inflation in all service prices has been above 4 percent in every month since July 2023. Although inflation in service prices declined from January, it was still a very high 5.8 percent in February. Inflation in service prices not including housing rent was even higher at 7.5 percent. Such large increases in the prices of services, if they were to continue, wouldn’t be consistent with the Fed meeting its 2 percent inflation target.

Finally, some economists and policymakers look at median inflation to gain insight into the underlying trend in the inflation rate. If we listed the inflation rate in each individual good or service in the CPI, median inflation is the inflation rate of the good or service that is in the middle of the list—that is, the inflation rate in the price of the good or service that has an equal number of higher and lower inflation rates. As the following figure shows, although median inflation declined in February, it was still high at 4.6 percent and, although median inflation is volatile, the trend has been generally upward since July 2023.

The data in this month’s BLS report on the CPI reinforces the view that the FOMC will not move to cut its target for the federal funds rate in the meeting next week and makes it somewhat less likely that the committee will cut its target at the following meeting on April 30-May 1.

The Latest PCE Report and PCE Inflation v. CPI Inflation

Photo courtesy of Lena Buonanno.

Wall Street Journal columnist Justin Lahart notes that when the Bureau of Labor Statistics (BLS) releases its monthly report on the consumer price index (CPI), the report “generates headlines, features in politicians’ speeches and moves markets.” When the Bureau of Economic Analysis (BEA) releases its monthly report “Personal Income and Outlays,” which includes data on the personal consumption expenditures (PCE) price index, there is much less notice in the business press or, often, less effect on financial markets. (You can see the difference in press coverage by comparing the front page of today’s online edition of the Wall Street Journal after the BEA released the latest PCE data with the paper’s front page on February 13 when the BLS released the latest CPI data.)

This difference in the weight given to the two inflation reports seems curious because the Federal Reserve uses the PCE, not the CPI, to determine whether it is achieving its 2 percent annual inflation target. When a new monthly measure of inflation is released much of the discussion in the media is about the effect the new data will have on the Federal Open Market Committee’s (FOMC) decision on whether to change its target for the federal funds rate. You might think the result would be greater media coverage of the PCE than the CPI. (The PCE includes the prices of all the goods and services included in the consumption component of GDP. Because the PCE includes the prices of more goods and services than does the CPI, it’s a broader measure of inflation, which is the key reason that the Fed prefers it.)

That CPI inflation data receive more media discussion than PCE inflation data is likely due to three factors:

The CPI is more familiar to most people than the PCE. It is also the measure that politicians and political commentators tend to focus on. The media are more likely to highlight a measure of inflation that the average reader easily understands rather than a less familiar measure that would require an explanation.
The monthly report on the CPI is typically released about two weeks before the monthly report on the PCE. Therefore, if the CPI measure of inflation turns out to be higher or lower than expected, the stock and bond markets will react to this new information on the value of inflation in the previous month. If the PCE measure is roughly consistent with the CPI measure, then the release of new data on the PCE measure contains less new information and, therefore, has a smaller effect on stock and bond prices.
Over longer periods, the two measures of inflation often move fairly closely together as the following figure shows, although CPI inflation tends to be somewhat higher than PCE inflation. The values of both series are the percentage change in the index from the same month in the previous year.

Turning to the PCE data for January released in the BEA’s latest “Personal Income and Outlays” report, the PCE inflation data were broadly consistent with the CPI data: Inflation in January increased somewhat from December. The first of the following figures shows PCE inflation and core PCE inflation—which excludes energy and food prices—for the period since January 2015 with inflation measured as the change in PCE from the same month in the previous year. The second figure shows PCE inflation and core PCE inflation measured as the inflation rate calculated by compounding the current month’s rate over an entire year. (The first figure shows what is sometimes called 12-month inflation and the second figure shows 1-month inflation.)

The two inflation measures are telling markedly different stories: 12-month inflation shows a continuation in the decline in inflation that began in 2022. Twelve-month PCE inflation fell from 2.6 percent in December to 2.4 percent in January. Twelve-month core PCE inflation fell from 2.9 percent in December to 2.8 percent in December. So, by this measure, inflation continues to approach the Fed’s 2 percent inflation target.

One-month PCE and core PCE inflation both show sharp increases from December to January: From 1.4 percent in December to 4.2 percent for 1-month PCE inflation and from 1.8 percent in December to 5.1 percent in January for 1-month core PCE inflation.

The one-month inflation data are bad news in that they may indicate that inflation accelerated in January and that the Fed is, therefore, further away than it seemed in December from hitting its 2 percent inflation target. But it’s important not to overinterpret a single month’s data. Although 1-month inflation is more volatile than 12-month inflation, the broad trend in 1-month inflation had been downwards from mid-2022 through December 2023. It will take at least a more months of data to assess whether this trend has been broken.

Fed officials didn’t appear to be particularly concerned by the news. For instance, according to an article on bloomberg.com, Federal Reserve Bank of Atlanta President Raphael Bostic noted that: “The last few inflation readings—one came out today—have shown that this is not going to be an inexorable march that gets you immediately to 2%, but that rather there are going to be some bumps along the way.” Investors appear to continue to expect that the Fed will cut its target for the federal funds rate at its meeting on June 11-12.