How inflation gets measured, and why the numbers disagree
Two inflation figures can describe the same month and differ by more than a percentage point. Neither is wrong. They measure different baskets, weight them differently, and answer different questions.
Since central banks set policy against one of them while households experience another, knowing which is which explains a lot of the argument about whether inflation is under control.
What a price index does
An index tracks the cost of a fixed basket of goods and services over time. Statisticians survey prices for thousands of items each month, weight each by how much of household spending it represents, and report the change.
Two decisions inside that process drive most of the disagreement between measures: what goes in the basket, and how the weights get set.
CPI and PCE
The United States publishes two main measures, and they routinely differ.
The Consumer Price Index comes from the Bureau of Labor Statistics. It tracks out-of-pocket spending by urban households, using weights updated from a survey of what people say they buy. It is the index used to adjust Social Security payments, many wage contracts and the tax brackets.
The Personal Consumption Expenditures price index comes from the Bureau of Economic Analysis. Its basket is broader, covering goods and services bought on households' behalf, most importantly medical care paid by employers and government programs. Its weights update continuously.
The Federal Reserve targets PCE inflation, which is why a hot CPI print sometimes produces less policy reaction than the coverage implies.
Three structural differences make PCE run lower than CPI most of the time.
Substitution. PCE weights adjust as buying patterns change, so when beef prices rise and shoppers buy chicken, the index reflects it. CPI weights are updated less often, so it captures less of that switching.
Scope. Medical costs paid by employers and Medicare count in PCE and not in CPI. Since those costs are large and have grown differently from out-of-pocket spending, the gap matters.
Weights. Housing carries a much larger share of CPI than of PCE, so when shelter costs move, CPI moves more.
Headline and core
Cutting the other way, each index comes in two versions.
Headline inflation includes everything. It is what households pay, and it drives perception, wage demands and political pressure.
Core inflation excludes food and energy. Those prices swing on weather, harvests and geopolitics, and the swings often reverse. Removing them gives a steadier read on the underlying trend, which is what a central bank acting with a one-to-two-year lag needs.
The exclusion is frequently criticized, and the criticism misunderstands the purpose. Nobody claims people do not buy food. The argument is that a central bank cannot influence oil prices with interest rates, and that reacting to a spike that reverses would tighten into a slowdown for no benefit. When energy prices rise persistently and feed into other prices, core captures it as it arrives.
Shelter, and the lag that confuses everyone
The single largest component of US CPI is shelter, and it is measured in a way that surprises people.
Rather than tracking home prices, the index measures the rental value of housing. For homeowners this uses owners' equivalent rent, an estimate of what an owner would pay to rent the same home. Home prices are treated as an asset purchase and excluded.
Rental data enters slowly, since leases reset once a year and the survey samples different units over time. Market rents can turn months before the index reflects it, which produces long stretches where the official shelter figure is describing a rental market that no longer exists. Anyone comparing CPI with current rent listings is comparing two different periods.
Why measured inflation can differ from your experience
Three reasons, all legitimate.
Your basket is not the average basket. A commuter with a long drive and a mortgage faces a different mix than a retiree who owns a home outright. The index describes a statistical household that exists nowhere.
Quality adjustment. When a product improves, statisticians treat part of the price increase as payment for a better product, not inflation. This is defensible and contested, and it is a real source of the gap between measured inflation and the feeling at the register.
Levels versus rates. Inflation falling from 9% to 3% means prices are still rising, just more slowly. Prices almost never fall back, which is why "inflation is down" and "everything is still expensive" are both true statements.
What to look at
For the trend, use core PCE, because it is what the Federal Reserve responds to. For the household experience, use headline CPI. For the direction of travel, look at the month-over-month change annualized rather than the year-over-year rate, since the annual figure is still carrying eleven months of history. When a big move drops out of the twelve-month window, the annual rate changes without anything new happening at all.
The terms involved
Inflation is the general rise in prices. Core excludes food and energy, while headline includes them. Deflation is a sustained fall in prices. Stagflation is weak growth with high inflation.
The archive has the questions these came from, and the glossary defines each one.
Common questions
What is the difference between CPI and PCE?
They measure different baskets and weight them differently. CPI comes from the Bureau of Labor Statistics and tracks out-of-pocket household spending. PCE covers a broader set of spending, including costs paid on a household's behalf, and adjusts its weights more often as people substitute between goods.
Why do two inflation numbers for the same month disagree?
Because two decisions inside the process differ: what goes into the basket, and how the weights are set. Both can be right at once. They are answering different questions, which is why the figure a central bank targets and the figure a household feels are not the same.
Which inflation measure does the Federal Reserve use?
The Fed sets policy against PCE, while public debate usually quotes CPI. That alone explains a good deal of the argument over whether inflation is under control.
Guess Macro is a daily word game built on this vocabulary. Five clues, one word each.