Economy

The Federal Reserve's favorite inflation indicator says it is under control

Key Points
  • As the Cleveland Fed puts it, the CPI measures what households are buying and the PCE looks at what businesses are selling.
  • On Friday, the Commerce Department said third quarter gross domestic product, rose an annualized 3.5 percent, and the PCE rose 1.6 percent in the quarter, below the 2.2 percent economists had forecast.
  • The CPI focuses on what consumers pay directly. The PCE is broader.
Pedestrians walk past the Federal Reserve building in Washington.
Andrew Harrer | Bloomberg | Getty Images

When it comes to monitoring inflation, the Federal Reserve watches a different number than the rest of us.

Headlines detail the latest Consumer Price Index changes, but the central bank monitors something a lot more esoteric-sounding, the Personal Consumption Expenditure deflator, or PCE price index.

Both measure inflation based on changes in the prices consumers pay for goods and services, but the two numbers are calculated by different agencies using different factors. As the Cleveland Fed once put it, the CPI measures what households are buying and the PCE looks at what businesses are selling.

On Friday, the Commerce Department said third quarter gross domestic product, which is the value of goods and services produced, rose by a 3.5 percent annual rate, slightly above expectations.

The PCE rose 1.6 percent in the quarter, below the 2.2 percent economists had forecast. The "core" PCE, which excludes food and energy prices, rose 1.6 percent, according to the Commerce Department's Bureau of Economic Analysis, which does the calculation. The PCE for September won't get released until next week. It was up 2.2 percent annualized in August.

Earlier this month, the Bureau of Labor Statistics, which is part of the Labor Department, said CPI for September rose an annualized 2.3 percent. or 2.2 percent without food and energy.

A broader measure

A big difference is what goes into the baskets of goods and services each index tries to measure. The CPI focuses on what consumers pay directly. The PCE is broader. For example, the PCE would factor in the cost of medical care paid by employee-sponsored health plans, Medicare and Medicaid, while the CPI would only take into account out-of-pocket spending by consumers themselves.

The two emphasize different factors, says Ryan Sweet, director of real time economics at Moody's Analytics. The PCE weights medical care spending while the CPI puts more weight on shelter costs. The PCE measures rural and urban spending, he added, while the CPI just looks at urban. And the PCE includes spending by non-profits not just consumers.

The PCE also factors in shifts in consumer behavior, for example, when people substitute cheaper items for more expensive ones. So, if the price of steak skyrockets and people start buying more chicken and less steak, the PCE's basket of goods would shift to reflect that, while the CPI's basket would remain the same as before.

The Bureau of Labor Statistics calculates the CPI using household survey data. The Bureau of Economic Analysis comes up with the PCE using the same data that goes into the quarterly gross domestic product report plus information from a variety of business reports, and it can revise that number just like GDP gets revised.

The Cleveland Fed says CPI has run about a half a percentage point higher than PCE since 2000, though only about 0.3 percentage points higher since 2008.

As for why any of it matters, the Fed has been trying to raise rates from historic lows without derailing an economic expansion. It wants to keep inflation in check without setting the economy back, often a tough line to walk.

"Going forward, data on inflation will be critical for the Fed" as it decides whether and when to raise rates again, Sweet said.