Evaluating Progress Toward the Fed's Inflation Target
Since January 2012, the Federal Open Market Committee (FOMC) has explicitly stated an inflation target of 2 percent. Since that time, most measures of inflation have been running persistently below that target. While in recent months some inflation indicators have made progress in moving back toward 2 percent, determining just how close we are to the FOMC’s target depends on which inflation measure we look at.
For example, measures based on the Personal Consumption Expenditures (PCE) price index indicate that progress has been made toward the 2 percent inflation target but that inflation still remains somewhat below the desired level. The year-over-year percent change in the PCE price index, which remained below 1.5 percent since early 2013, ticked up to near 1.7 percent in May and was at 1.6 percent in June. Additionally, inflation as measured by the core PCE price index, which excludes food and energy costs and is therefore a less volatile measure of underlying inflation, increased to 1.5 percent by June after staying in a narrow range around 1.3 percent over most of the past year.
In contrast, measures based on the Consumer Price Index (CPI) give a different impression of where we are in relation to a 2 percent target. The year-over-year percent change in the CPI increased to 2.0 percent in April of this year and has remained near that level through July. Core CPI inflation increased to 2.0 percent in May, and as of July, was at 1.9 percent. Evaluating current inflation levels with the CPI could lead us to think that we have been right on target over the past few months.
But it isn’t quite right to use common CPI measures of inflation to assess proximity to the FOMC’s longer-run inflation goal. The FOMC’s target is based on the Committee’s preferred measure of inflation —the PCE price index. Normally, CPI inflation runs higher than PCE inflation; since 2001, the difference has been about 0.4 percentage points. There are a number of reasons that CPI inflation commonly exceeds PCE inflation, having to do with the different purposes of the price measures and their construction.
One of the primary drivers of the difference in PCE and CPI inflation rates is known as substitution bias. As the price of one good goes up relative to another, consumers will make substitutions in their purchases, to spend less on the now more expensive good and more on the newly cheaper item. The PCE measure of inflation does a better job of capturing this kind of substitution than does the CPI. Both the CPI and the PCE price index are weighted averages of price indexes for individual categories of goods and services, where the weights are determined based on the composition of consumption. The weights used in the construction of the PCE index are updated each month based on the composition of consumption in that month, while the weights used in the CPI are not. The weights in the CPI are adjusted, but at a lower frequency. As a result, the CPI does not do as good of a job as the PCE price index at capturing substitution, which causes CPI inflation to (on average) exceed PCE inflation.
However, there is a version of the CPI that attempts to account for substitution in a manner similar to the PCE price index: the chain-weighted (or chained) CPI. For the chained CPI, the weights for each individual category are adjusted monthly in order to keep up with changes in consumption. This eliminates the substitution bias in the CPI. Over time, the average rate of inflation in the chained CPI is similar to the average rate of inflation in PCE prices (both overall and the PCE excluding food and energy). As a result, for comparing CPI inflation to the FOMC’s 2 percent inflation goal, the chained CPI is more appropriate than the more widely publicized, simple CPI.
Over the past couple of years, it turns out that chained CPI measures paint a picture pretty similar (although not exactly the same) to the one painted by PCE measures. Inflation in the chained CPI has been very similar to PCE inflation, until very recently, when the chained CPI moved somewhat above PCE inflation. In fact, as of June, inflation in the chained CPI was 2.0 percent, while PCE inflation was 1.6 percent. For core inflation, the chained CPI excluding food and energy has been running consistently a little higher than core PCE inflation, but following a very similar pattern from month to month. At present, core chain CPI inflation is a little below 1.8 percent, while core PCE inflation is 1.6 percent.
Putting all of this together, the chain CPI, like the PCE, shows some recent progress toward the FOMC’s longer-run inflation goal of 2 percent, with chain CPI inflation a little closer to 2 percent than PCE inflation has been.