Inflation

The Consumer Price Index (CPI) and the Personal Consumption Expenditure (PCE) Price Index are both essential measures of inflation, but they have distinct characteristics. Let’s delve into their differences:

1. Formulaic Differences:

   • CPI: The CPI uses an index formula that updates item weights biannually (moving to annual updates in 2023). This less frequent update can lead to higher CPI values because it doesn’t fully capture consumers’ tendency to switch to cheaper products when prices change.
   • PCE: The PCE index updates item weights quarterly, which better captures substitution effects. It considers consumers’ behavior in response to relative price differences.

2. Scope Differences:

   • CPI: Focuses on a narrower definition of consumer expenditures, considering only urban expenditures made directly by consumers.
   • PCE: Encompasses a broader range of goods and services, including urban and rural consumer expenditures and expenditures made on behalf of consumers by third parties (e.g., healthcare insurance providers purchasing prescription drugs for patients).

3. Weight Differences:

   • CPI: Assigns higher weights to categories currently experiencing higher inflation levels (e.g., shelter costs), which contributes to its traditionally higher values.
   • PCE: Reflects a different weighting structure due to its broader scope, including third-party expenditures. Healthcare-related expenses significantly impact the divergence between PCE and CPI.

4. Other Differences:

   • CPI: Measures prices at the end-user level and includes all prices.
   • PCE: Preferred by the Federal Reserve, it considers both urban and rural expenditures and strips out food and energy prices to focus on core inflation.