CPI, PPI And PCE – What’s The Difference Between U.S. Inflation Measures?
Recent inflation has grabbed everyone’s attention. This includes the stock and bond markets and the U.S. Federal Reserve (Fed). However, with several different measures of inflation released at different times, and lots of three-letter acronyms – how can you interpret the latest government figures on inflation?
Here we’ll review the main U.S. inflation metrics, and their similarities and differences, as well as more recent trends in the rise of nowcasting of inflation data.
What Is Inflation?
First off, it’s helpful to review what inflation is measuring. It is the change in prices over a given period, typically a month or year.
It can help to think about this using the analogy of your weight. Inflation isn’t like measuring your weight directly, but how much your weight is changing. So inflation is telling you, not that you weigh 170lbs, but that you have put on 5lbs over the past year.
This means inflation data tells us if prices are rising or falling and how fast. You can probably see that inflation is also a series that has a strong trend component to it. For example, coming back to the weight example, if you gain five pounds in January then unless something changes then you’ll unfortunately still have those five pounds for the rest of the calendar year.
That’s one reason inflation is high currently, prices have risen a lot over the past 12 months, and even if new data enters the series with steadier prices, prices are expected to stay high for a while as prior month’s effects are still included in the inflation series.
Inflation is typically described on a year-on-year basis, so saying that inflation is at 8% for September 2022, means that prices are 8% higher, on average, in September 2022 than in September 2021.
Consumer vs. Producer Costs
Then one of the fundamental differences in inflation data is whom prices are being measured for. Consumer Price Index (CPI) and Personal Consumption Expenditure (PCE) data measure costs for consumer goods and services. In contrast, Producer Price Index (PPI) measure costs for producers, such as businesses. The PPI was once called the Wholesale Price Index (WPI) which may be a simpler description of what it’s measuring – whole prices rather than consumer prices.
What Makes PPI Unique
This makes the PPI data somewhat unique. It tells us how prices are changing for primarily for businesses, not for consumers. Many economists think that because producers are earlier in the supply chain, PPI inflation can be a leading indicator of inflation.
For example, if prices are rising or falling for steel, then it may appear in the PPI inflation first, and then that cost is passed onto consumers in subsequent weeks or months as they purchase final products and services that incorporate steel. However, though there is an impact here, research suggests that the relationship is weaker than you might expect.
One reason for this is that businesses add on a margin to make a profit, and those margins change over time and impact the prices consumers pay. Though margin changes don’t appear in the PPI data and can make a big difference to consumers.
PPI is useful measure of what’s going on in the U.S. economy and gives useful insights. Yet, it’s a little removed from the prices that consumers are actually paying today.
CPI vs. PCE Inflation
Then we have the two most common measures of the prices that consumers are paying. From a financial market standpoint, CPI inflation is released earlier in the month for the prior month, so often gets a little more attention.
PCE inflation is released a few weeks later, so is often less of a surprise as PPI. CPI data have already been released for the same month once we see the PCE numbers.
From a high level perspective, the two measures are quite similar. You can see a recent comparison of the series here and the differences have historically been fairly small. Nonetheless, PCE inflation tends to come in a little lower than CPI inflation. The differences are worth noting.
CPI inflation measures the cost consumers pay directly. PCE inflation also includes services for consumers that are paid for by others on behalf of consumers, such as by employers or non-profits.
The most common example used to explain this is healthcare costs. CPI just measures consumers out-of-pocket costs for healthcare, whereas PCE measures healthcare services for consumers that are paid for by others, such as employers.
Perhaps the biggest challenge when determining inflation is how you weight different prices to arrive at average inflation. CPI and PCE do this using different techniques. CPI uses consumer expenditure surveys to determine what households are purchasing. PCE uses NIPA data on what businesses have sold to consumers.
Urban vs. Not
CPI measures prices for urban consumers, whereas PCE includes all prices, both urban and rural.
Index Construction Differences
CPI uses a Laspeyres formula and PCE uses a Fisher formula to construct their inflation metrics. Generally the PCE’s formula is considered superior. It is quicker to pick-up on changes in what people are buying.
However, remember CPI comes out earlier so still gets a lot of attention. Also again, looking at historical data these differences are very interesting to statisticians, but don’t tend to change the reported data all that much.
However, the CPI’s method is quicker and simpler as the spending on different items is held constant over a period of time, typically 1-2 years. That can mean that CPI data can overstate inflation due to being slower to recognize consumer substitutions.
For example, if the price of bananas went to $20 each, it’s quite likely that most consumers would buy a lot fewer bananas and switch to buying more apples or other fruits. PCE data would, theoretically, pick up on this during the month it occurred as business sales for bananas would fall. However, the CPI index would only pick up a change with its next weighting update which could be 1 or 2 years away. This is one reason CPI inflation can come in slightly higher than CPE inflation on average.
If you want to get into the details of price trends. CPI can actually offer more color. The CPI breaks out price changes for different products and services in quite a lot of detail. This means that if you want to know the monthly price change for peanut butter, it’s there, buried in the pages of the CPI report.
In contrast the PCE inflation data is more high level. This matter if you want to unpack the trends in inflation in different parts of the economy to better understand price changes or focus on very specific price trends for certain items.
Which Is Better PCE or CPI?
The Fed has a preference for PCE data as a broader and more robust measure of inflation. PCE updates weightings more frequently, includes urban and rural prices and covers items bought on behalf of consumers as well as goods and services consumers buy directly.
However, the two metrics are historically fairly similar, though CPI will often tend to trend a little higher, and even though the PCE numbers may be more robust, CPI comes out weeks earlier which counts for a lot when it come to financial markets. The CPI also contains more granular information on price changes, which can be helpful if you want to drill in.
Lastly, we have the recent trend for nowcasting. While inflation data is generally released pretty soon after the prior month ends, nowcasting can be even quicker.
Rather than wait for the CPI to tell you what gas prices were a few weeks after the fact, you can, of course, look online right now and find out. Since so much pricing information is now online whether at Amazon or elsewhere, innovative services can just scrape that information and show where prices are moving in real time.
This approach may lack some of the statistical sophistication of PCE models, and can be opaque, but it more than makes up for it by providing an immediate take on what’s happening that is fairly accurate.
The Cleveland Federal Reserve offers a nowcasting service for inflation which is updated daily and can be found here. These nowcasts can be pretty good, and provide a reasonable signal on where prices may be heading.
Which Is The Best Inflation Measure?
All inflation metrics have something to offer. Nowcasts can provide an early signal on inflation trends almost in real time. PCE inflation is probably the most robust inflation metric overall. Still, CPI data is released earlier and is seldom too different, so CPI is helpful in forming a view on where inflation is trending sooner.
Then PPI is measuring prices for businesses, which is quite a different topic, but certainly related. This can provide useful insights on price trends in the economy.
Across the different inflation metrics, all have their uses. The one thing we can say is that the Fed would like them all to be lower than they are currently.