CPI, PPI and PCE: The relationship between inflation measures

In 2022, US inflation reached a record high in over 40 years, causing the Fed to tighten monetary policy, raising interest rates to 5.25%-5.50% in July 2023. Up to the present time, as inflation has cooled and approached the 2% target, the top concern of investors is when the Fed will start cutting interest rates.

When tightening, the Fed uses the PCE price index as the inflation measure for its interest rate balancing model. Even Goolsbee (Chicago Fed) affirmed: The Fed's inflation target is PCE, not CPI in the statement on 02/14.

However, the traditional CPI consumer price index is more commonly used internationally and causes stronger market reactions.

In this week's article, Viet Hustler will answer these questions by explaining the differences between the inflation measures PPI, CPI, and PCE, while examining their market implications.

Consumer Price Index CPI (Consumer Price Index)

The Consumer Price Index CPI measures the weighted average price fluctuations of a typical basket of goods that consumers have to pay currently compared to prices in a base period (base period).

• Currently, this index measures the change in current prices compared to the average prices of the 1982–84 period (base period).

  • For example: the CPI index for March 2024 is 312.332 points ~ meaning 100 USD in 1982-1984 has the equivalent value of 312.33 USD in March 2024.

    

• This is the oldest (dating back to World War I) and most popular measure of inflation/deflation.

Some highlights in the CPI index

• CPI sensitively reflects the impact of short-term price increases:

  • Because it originates from consumer surveys, so as soon as

    Wage inflation < CPI inflation → Real income is decreasing → Consumer confidence decreases → Spending decreases.

• The housing cost category (shelter) accounts for more than 1/3 of the CPI weight as of December 2023.

How BLS (Bureau of Labor Statistics) calculates CPI:

Basket of goods:

In the CPI-U index (for urban areas - Urban, also the main index), data is collected in 38 areas (index areas) with 211 commodity groups for each area (item strata).

=> Total of 8,018 (38 × 211) item-areas used to calculate CPI.

Step 1: Calculate the price change level for each item

• Calculate the price index for each component in the basket of 8,018 items (item-areas) = current price ratio to base period (base period).

Step 2: Calculate the aggregate CPI index

• Calculate the average of 8,018 price indices from 8,018 components after multiplying these indices by weights for each commodity group.

• The weights for averaging in this step are taken from Consumer Expenditure Survey of residents (Consumer Expenditure Survey - CE)

Inflation rate according to CPI: percentage change rate of current CPI compared to the previous period (previous month: M/M, previous year: Y/Y).

→ Therefore, CPI value and inflation move in the same direction: Prices increase => CPI increases => Inflation increases.

• Details of the basket of goods, index areas, and calculation method here.

Some limitations when calculating inflation using the CPI index

• Not representative enough: The CPI basket mainly consists of consumer goods, not covering all industries.

• Does not reflect substitute goods: When an item becomes more expensive, consumers tend to buy cheaper substitutes.

  CPI does not reflect this but assumes consumers continue to buy the same amount of increasingly expensive goods.

• Does not reflect new products: Consumer products, even when improved in quality, will not be included in the CPI basket until they are considered essential consumer goods.

• Focus only on urban consumption: CPI does not provide a measure of prices for consumers in rural areas.

• Does not reflect specific types of spending: CPI typically only reflects out-of-pocket expenses paid by individuals.

  • For example, CPI only reflects medical expenses paid directly by users but ignores support from insurance companies.

Producer Price Index PPI (Producer Price Index)

Producer Price Index PPI reflects changes in the selling prices of products from producers and various industries. Therefore, PPI measures changes in prices from the wholesaler side / finished goods prices from producers.

• BLS typically releases PPI at 8.30am EST at the beginning of the second week each month.

  • PPI is based on 100,000 price quotes from over 25,000 systematically sampled production facilities.

• Every industry and commodity has a PPI index; in fact, there are nearly 10,000 types of indices: mining, manufacturing, fishing, forestry, agriculture, natural gas, electricity, construction, goods, services,…

PPI calculation formula:

Until 1978, the Producer Price Index PPI was called the Wholesale Price Index (WPI). In 1982, BLS reset all PPI bases to 100 => 1982 became the new base period.

Relationship between CPI and PPI

PPI reflects price trends before the Consumer Price Index CPI

• CPI reflects consumer prices, PPI reflects finished goods prices from producers (wholesale prices) for both consumer goods and production materials.

• Producers will gradually pass cost burdens to consumers (e.g., price increases,…)

  → PPI increase signals future price increases → CPI follows.

PPI index is usually higher than CPI (note: it's the index level, not the growth rate)

• When business costs rise, businesses do not always pass those costs to consumers immediately.

• Additionally, PPI mainly measures goods, while CPI measures both goods and services.

Some other differences

• Differences in measurement healthcare services:

  • PPI: Healthcare services account for up to 16.6%.

    

  • Conversely, CPI: the healthcare sector weight is 8% because it does not measure third-party healthcare reimbursements (such as insurance).

    

• Difference in rent costs:

  • PPI does not measure fluctuations in total housing costs.

  • CPI's housing category includes rent, accounting for up to 1/3 of the overall index.

• Difference in imports and exports:

  • PPI only includes exports, does not include imports because they are not produced by domestic businesses.

  • CPI only includes imports, does not include exports, because there are consumer goods and services bought by domestic consumers.

    • Imports account for a significant portion of CPI, especially in apparel and automobiles.

Personal Consumption Expenditures Index - PCE (Personal Consumption Expenditures)

Personal Consumption Expenditures PCE is a measure of consumer spending on goods and services.

• PCE accounts for 2/3 of domestic spending and is an important driver of GDP.

Consumer Expenditure Survey (Consumer Expenditure Survey - CE) from the Bureau of Labor Statistics (BLS) and PCE from the Bureau of Economic Analysis (BEA) are 2 important household spending data.

• Therefore, unlike CPI which is a price change index, PCE is an aggregate of consumer spending amount - similar to CE.

  

• Note: PCE estimates are not taken from a dedicated consumer survey sample like CE (Consumer Expenditure Survey) but based on spending statistics reports from government agencies, administrative agencies, and private organizations/businesses (e.g., trade associations).

  • Therefore, retail sales do affect PCE!

  • Meanwhile, CE is used to calculate weights when calculating the CPI index.

• Details: Calculation method and goods categories of PCE compared to CE (and CPI).

Components of the PCE measure

• Durable goods: Motor vehicles and parts, furniture and durable household equipment, recreational goods and vehicles as well as other durable goods

FYI: Durable goods have a useful life > 3 years such as cars, electronics, equipment, furniture,…

• Nondurable goods: Food and beverages purchased for off-premises consumption, clothing and shoes, gasoline and other energy goods, and other nondurable goods

FYI: Nondurable goods have a useful life < 3 years such as cosmetics, gasoline, clothing,…

• Services: such as health care, transportation services, recreation services, food services and accommodations, financial services and insurance,…

Factors affecting PCE

Factors affecting the PCE index include: disposable income, taxes, consumer confidence, income expectations, inflation expectations and interest rates.

• Disposable income: Income increases → Spending increases → PCE increases.

• Taxes: Taxes increase → Disposable income decreases → Spending decreases → PCE decreases.

• Consumer confidence: Consumer confidence particularly affects the durable goods group. High consumer confidence → Consumers tend to buy more goods → PCE increases.

• Income expectations: Rising income expectations → Consumers believe they will have financial capacity in the future → Spending increases.

• Inflation expectations: Inflation increases → Purchasing power decreases. Therefore, when consumers predict that future inflation will rise, they will spend more currently to avoid being affected by inflation.

• Interest rates: High interest rates → High borrowing costs → Spending decreases → PCE decreases.

Differences between PCE and CPI

• Scope: CPI only measures spending of urban households, while PCE measures spending on goods and services by all households and nonprofit organizations.

  → Wider measurement scope increases accuracy.

• PCE spending measure is more comprehensive:

  • CPI only includes out-of-pocket payments, while PCE includes both out-of-pocket payments and indirect expenses such as insurance company payments to consumers.

  • Reflecting substitute goods: When prices rise high causing consumers to choose other substitute goods, the PCE index changes to reflect changes in spending decisions. CPI does not.

    → PCE will be less volatile than CPI.

• PCE can be revised after release. CPI cannot be revised.

• Differences in airline ticket price data: CPI calculates for the airline travel industry and fixed routes. PCE is based on passenger revenue and passenger miles flown.

PCE growth and CPI growth usually indicate the same inflation trend. However, CPI growth is usually higher than PCE growth.

→ PCE data is more comprehensive, making it the Fed's preferred inflation measure.

• However, CPI is an index measuring price changes through direct surveys from a sample of consumer data.

In 2000, the FOMC meeting officially announced the switch from using CPI to PCE to build the inflation forecasting framework.

Conclusion

Fed and central banks around the world, when implementing monetary policy, always monitor transient fluctuations and trend fluctuations of inflation. Accurate inflation measurement will help monetary policy decisions be more appropriate to control and maintain price stability. The most popular inflation measures include:

• Producer Price Index PPI, measuring the degree of price fluctuations of producers.

• Consumer Price Index CPI and PCE, measuring price fluctuations of daily consumer goods and services of the people.

Among the 3 indices above, PCE and CPI are quite similar. CPI is widely used because it better reflects the short-term impact of price increases on consumers. However, the Fed uses PCE as the preferred inflation measure due to its broader measurement scope than CPI, increasing accuracy. Additionally, some PCE measurement methods address CPI's limitations, so since 2000, the Fed has officially used PCE to build the inflation measurement framework. In summary, all 3 indices PPI, CPI, and PCE have their own strengths and weaknesses, so the choice of index to monitor depends on the research purpose.