Inflation has become the dominant topic in financial and economic markets, but what exactly is inflation, and how is it measured?
We can’t just talk about a rise in the price level—which is the technical definition of inflation—because there are many price levels. Price level of what? We can’t measure everything all at once, so we need to select some items to measure for price changes. How do we select, who does the selecting, and why do they choose what they choose?
In the United States, there are two predominant measures of inflation: the consumer price index and the personal consumption expenditure.
There are three main differences between the two: 1. Formula (i.e., the math used to calculate both is different); 2. Weight (different items are weighted differently in both); and 3. Scope (the CPI is limited to just urban households, while PCE includes urban and rural households as well as nonprofit institutions). There are some other smaller differences, such as differences in seasonal adjustment, but these are relatively minor.
To really understand inflation, one needs to look at the constituents of both CPI and PCE; these are no secret and are available from the BLS and the BEA. Data about the makeup of the indices, their methodology, and changes to their methods are available on both websites. This is no surprise; both agencies are run by economists who want to provide as much detailed data to researchers and market participants as possible.
The Federal Reserve prefers PCE because of its broader scope, but that doesn’t mean PCE is necessarily better. If, for instance, you are looking at buying or selling a company whose primary business is in urban areas, CPI may be more useful for your model. But knowing both in depth will help you determine which is right for you.
Now, we can go further and dig into the parts of the indices. For simplicity’s sake, we’ll focus on CPI, but the principles apply to both.
The CPI is split into four main categories: food, energy, all items less food and energy, and services less energy services. Differences in core-CPI (that is, all items less food and energy) tend to be less volatile than headline CPI (all items including food and energy), which is why they are often looked at separately.
Within these are sub categories (food at home and food away from home, for example), and within those are sub-sub categories—which can get very detailed!
Again, all of these are released monthly and are available to view on the BLS’s website. Some of these categories are very controversial—owner’s equivalent rent of primary residence is one of them. This is a hypothetical counterfactual—if a homeowner did not own her own home but instead rented, how much would that theoretical rent go up? Because this is not actually money going into the economy, a very heavy increase in this category could skew inflation numbers upwards. However, there has been a solid argument made that the category has lowered volatility in the metric and has made it a more accurate reflection of actual price changes, particularly when looking at populations with high home ownership rates (and America, relatively speaking, has such a high rate of home ownership).
And this is why digging into an inflation metric is important—understanding its constituents and dialing in what features of the metric are relevant for your purpose is crucial to using the metric correctly. Those who simply rely on headline numbers can easily get skewed by volatility or irrelevant details to their specific purpose.