PCE Inflation, How It's Calculated, and Why the Fed Prefers It

The Personal Consumption Expenditures Price Index (PCEPI) measures price changes for household goods and services. Increases in the index warn of inflation while decreases indicate deflation.

The PCEPI is also called the PCE price index. Of all the measures of consumer price changes, the PCEPI includes the broadest set of goods and services.

How It's Calculated

The Bureau of Economic Analysis (BEA) estimates the PCE price index each month and publishes its findings in a report called "Personal Income and Outlays."

The BEA uses the same data that creates the quarterly gross domestic product (GDP) report that measures U.S. economic output but the PCE price index measures consumer purchases through different calculations:

1. The BEA estimates how much is being consumed based on the GDP data from suppliers. That figure includes manufacturers’ shipments, revenue for utilities, service receipts, and commissions for securities brokerage.
2. It adds imports, which the GDP report excludes.
3. The BEA then subtracts exports and changes in inventory to determine the amount available for domestic consumption.
4. It allocates the result of step three among domestic purchasers. It bases this on trade source data, Census Bureau data, and household income surveys.
5. The BEA converts the prices, which are still the producers' prices, to the end price paid by the consumer. It bases the prices on the Consumer Price Index (CPI).

It adds the cost of profit margins, taxes, and transportation costs. The BEA includes data from the Census Bureau’s Economic Censuses, International Transactions Accounts, and various government agencies. For example, the price for food that is grown and eaten on the farm is derived from the Department of Agriculture or the USDA.  

Since the GDP report is quarterly and the PCE price index is estimated monthly, the BEA must estimate even further to fill in the gap, so it uses the monthly retail sales report.

PCE Price Index vs. CPI

Although they both measure inflation, there are subtle differences between the PCE price index and the CPI. The most noticeable difference is that the PCE price index is not as well known as the Consumer Price Index.

The PCE index uses data from the GDP report and businesses, while the CPI uses data from household surveys the Bureau of Labor Statistics creates. It surveys around 14,500 families and collects prices for about 80,000 consumer items. The CPI includes sales taxes but not income taxes.

The PCE price index counts health care services paid for by employer-sponsored health insurance, Medicare, and Medicaid. The CPI only counts medical services paid for directly by consumers.

The PCE price index measures goods and services bought by all U.S. households and non-profits. The CPI only measures all urban households.

The PCE price index and the CPI use different types of formulas to calculate price changes. The CPI formula is more likely to be affected by categories with wide price swings such as computers and gasoline. The PCE calculations smooth out these price swings, which makes the PCE less volatile than the CPI.

PCE vs. CPI Comparison

The Fed's Preferred Measure of Inflation

On Jan. 15, 2012, the Federal Reserve stated at its monthly Federal Open Market Committee meeting that it would use the PCE price index as its primary measure of inflation.

The Fed preferred the PCE for three primary reasons:

1. The PCE formula responds more fluidly to changing consumer preferences.
2. It includes a more comprehensive list of expenditures.
3. Historical data can be revised to reflect new data.

Core PCE Inflation

The core PCE price index measures core inflation. It excludes volatile oil, gas, and food prices. By excluding those categories, it gives a better look at underlying inflation trends.

Why are oil, gas, and food prices so volatile? The commodities markets determine oil prices, which consequently affect gas and then food prices. When traders expect oil supply or demand to change, they speculate on oil prices.

The strength of the dollar also affects oil prices. The core PCE price index removes that volatility and gives an accurate picture of real inflation. It reports on all types of inflation.

The Fed compares the core PCE inflation rate to the Fed's 2% target inflation rate. If it is below 2%, the Fed will lower interest rates and use its other tools to spur consumer demand. If the core rate is above 2% for an extended period, then the Fed will take action to prevent inflation.