There are many measures of inflation available. Which one should we be focusing on? The July CPI was announced this week, and Federal Reserve’s preferred measure, the PCE index, will be announced on August 26. These two series each have variations, and there are still other measures available. Understanding how each one is calculated helps us understand what each one is actually measuring, and should help match the measure to the application.

The Issue

As the monetary policy folks and the public at large are laser focused on inflation data, looking for signs of whether or not prices have peaked, it becomes even more important to understand the differences between the various inflation measures. This Jason Furman commentary from the Wall Street Journal (subscription may be required) is a great example of how economists use and make references to a variety of data. Let’s take a closer look at how these series are derived and what they measure.

The Consumer Price Index is most often quoted when discussing inflation. It is extremely detailed, using a market basket of 94,000 goods and services. One reason for the interest in this particular measure is that it is the basis of many “cost of living” adjustments to benefits such as Social Security. CPI measures consumer's out-of-pocket costs.  There are several different cuts of the data, and the detail in the BLS monthly release is illuminating and worth a closer look. The next most often quoted series is the variation “Core CPI,” which excludes food and energy from the basket, as they are the most volatile.

The Inflation Center at the Federal Reserve Bank of Cleveland has a public facing resource called Inflation 101, with general and technical versions. The technical option discusses what inflation is and why there are so many different measures. It also includes a link to an 8 ½ minute video, which does a great job of explaining the Median CPI and why it might be more useful in understanding the direction of prices in general, as the basic CPI can be highly influenced by large price increases in just a few goods. (Even the Core CPI can be influenced by a large component of consumer spending, like housing.) The chart shows how different each of these measures of CPI turns out to be. If you look at the median CPI (orange), there does not appear to be an inflection point yet with the most recent data as there appears to be in the other three—an interesting point to monitor.

Chart from FRB Cleveland website.

If you are following the Federal Reserve Open Market Committee decisions and commentary, you often see that the Fed uses the PCE price index over the CPI. There are a few key differences that make it a more relevant measure, in their view. One difference is that PCE covers the total cost of expenditures made by and on behalf of consumers.  As a result, something like health care expenditures has a bigger weight in the PCE measure than in the CPI, because it includes the total cost, not just the out-of-pocket component of expenditures.   Another big difference in weighting is that the CPI market weights do not change often, but the weighting in the PCEPI calculation is fairly fluid, picking up changes in consumption trends quickly. (For a thorough explanation of the differences, try the link to a PDF of a commentary found in this abstract of the paper.) Core PCE excludes food and energy, as is done with the CPI, for the same reason. The Dallas Fed takes this same data and trims away the components whose prices have increased and decreased the most, and calculates the weighed average of what is left. They feel this gives a better measure of “core” prices than simply removing food and energy.

Then there are the Producer Price Index and the GDP deflator. The PPI gives us an idea of the wholesale costs of all those goods and services consumed, and more directly reflects the prices of inputs. The GDP deflator looks at the all goods and services produced within the United States, regardless of who purchases or consumes them. This will include Government expenditures and exports.

Quick Guide to Inflation Measures

Lesson Idea

1. Assign the different series to your students as time allows (individually or groups, one or more series per group.) Have them research the series, how it is calculated, how it is used, and any issues or biases that might be found with it. They can start by using the links provided in the table above, and look to the source (most recent announcements of data releases).
2. Have students report their findings either in writing or to the class.
3. Expand the table (Quick Guide) above to include columns like “used by or for,” “potential bias” and “other” for any other comments or interesting findings the students may come up with.  Either as a class or subsets of the class that have covered all measures, fill in those extra columns in the table.

About the Author

Beth Tallman

Beth Tallman entered the working world armed with an MBA in finance and thoroughly enjoyed her first career working in manufacturing and telecommunications, including a stint overseas. She took advantage of an involuntary separation to try teaching high school math, something she had always dreamed of doing. When fate stepped in once again, Beth jumped on the opportunity to combine her passion for numbers, money, and education to develop curriculum and teach personal finance at Oberlin College. Beth now spends her time writing on personal finance and financial education, conducts student workshops, and develops finance curricula and educational content. She is also the Treasurer of Ohio Jump$tart Coalition for Personal Financial Literacy.