Introducing Students to Inflation Indexes

For monetary policymakers, the rate of inflation, or the overall rate of the increase in prices, influences the actions they take to promote long-run price stability. Inflation concerns everyone because it reflects an overall decline in the purchasing power of their money.

The first-quarter 2011 issue of the Atlanta Fed's EconSouth includes an article that highlights the important distinction between inflation and the cost of living—concepts that are often confused with one another. The bottom line is that inflation happens when a central bank issues more money than the public wants to hold. Central banks control the amount of money circulating in the economy and thus control inflation. On the other hand, central banks cannot control changes in the cost of living, or price increases of particular goods, such as gasoline, and services. Central banks do not produce commodities, so they do not control relative-price changes.

Part of the Federal Reserve's "dual mandate" is a commitment to stable prices. Having an accurate gauge of inflation means that policymakers can make well-informed decisions.

Consumer and producer prices
There are many different price indexes. Students may recognize two of them: the consumer price index (CPI) and the producer price index (PPI). Both of these measures take a "market basket" approach—they measure the cost of a specific basket of goods. The CPI market basket is based on the out-of-pocket spending by urban (or metropolitan) consumers. The PPI tracks a basket of goods produced by U.S. industry. Market-basket price indexes, including the CPI, are calculated as weighted averages. This means that certain components of the index are relatively more important than other components. Consequently, what someone has chosen to put into the market basket can have a significant effect on how quickly the price statistic rises from month to month.

Consumer spending
Consider another key measure of inflation: the personal consumption expenditure (PCE) index. Like the CPI, this index reflects the cost of a market basket of consumer goods—the goods that go into the consumer spending component of gross domestic product (GDP). The PCE price measure is different from the CPI in that it also includes spending by nonprofit institutions that serve households and personal medical expenses that employers pay on behalf of households.

Since early 2000, the Federal Reserve Board of Governors has expressed its inflation outlook in terms of the PCE. One reason the Fed chose the PCE measure over the CPI is that the PCE market basket is thought to weigh more accurately how much people pay for certain things, perhaps most notably medical care and housing (the PCE measure gives a greater weight to the former, a smaller weight to the latter).

The Federal Open Market Committee (FOMC)—the Federal Reserve's monetary policymaking body—implements monetary policy with the goal of maintaining a 2 percent inflation rate over time as measured by the annual change in the PCE. Having some small level of inflation reduces the chance of deflation—or a fall in prices and wages—if economic conditions were to weaken. And although the FOMC uses core PCE for inflation monitoring, it is the overall PCE price measure that is the basis for their inflation target.

Headline versus core inflation
What is the difference between core and headline inflation? As it is usually measured, core inflation excludes food and energy from the market basket. Of course, food and energy are important to us all, but food and energy prices tend to be extremely volatile, and that makes tracking the inflation trend harder to do from month to month. In fact, core inflation has proven to be a better predictor of future overall inflation trends than has headline inflation, which includes food and energy.

Measuring core inflation helps policymakers see through the short-term price changes of certain goods that may not be representative of the longer-term trend in the overall price level. Lots of things can happen to cause a sudden and temporary price changes in certain items, and perhaps food and energy goods most of all. For example, a drought or storm can damage farmers' crops, resulting in a sharp but transitory increase in food prices. This does not mean that these price increases are not important to consumers. However, it does mean that these price increases are likely temporary, and the change may not reflect the trend in the economy's overall price level that is under the control of the Federal Reserve.

Economists debate the best ways to compute core inflation. Although excluding the prices of food and energy goods from indexes may help with predicting longer-term price trends, economists also use more involved ways to calculate core inflation. The trimmed-mean PCE inflation rate, for one, involves leaving out a certain fraction of the most extreme price changes of components that make up the index. By leaving out the most dramatic price changes at both ends of the spectrum, economists hope to come as close as possible to core inflation, according to the Federal Reserve Bank of Cleveland.

So what does it all come down to?
There are lots of forces at play in the determination of the inflation trend. Money and credit trends, labor costs, commodity prices, producer prices, and inflation expectations are all influential to the inflation trend. And there are lots of data available to help policymakers anticipate when these forces are on the rise or on the fall. To help keep track of the trends in all of the various inflation indicators, the Federal Reserve Bank of Atlanta has made an "inflation dashboard" that is updated every time a new data point becomes available.

The important point to keep in mind is that the Federal Reserve considers a variety of indicators, and many inflation measures so they can track the trend in the PCE price index. And after students become familiar with the different indexes—including the CPI, PPI, and PCE—and with the concepts of headline and core inflation, they can understand how the prices they pay, whether for an ice cream cone, movie ticket, or gasoline, fit into the larger economic picture.

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By Elizabeth Bruml, an economics major at Emory University in Atlanta, who contributed this article as part of her internship at the Federal Reserve Bank of Atlanta
October 31, 2012