The Consumer Price Index (CPI) and Personal Consumption Expenditures Price Index (PCE) are both common indexes tracking changes in price levels over time, commonly known as inflation or deflation.
The Federal Reserve Bank uses the PCE to track inflation, despite the CPI certainly being a more common and reported-on metric. To understand these differences and why the Fed uses the PCE, let’s explore some core differences between these two price indexes:
First: both indexes are similar in that they focus on consumption (consumption expenditure) and include imported goods to reflect, say, international oil prices in affecting domestic inflation.The CPI measures the price of a standard consumption basket for the normal urban consumer: basically, it measures cost of living across standard categories like food, medical care, and transportation. It’s a good indicator for home much more or less consumers need to spend to maintain their standard of living compared to a base year.The PCE measures the price of total consumption in the economy relative to a reference year. So, it captures the prices of all consumption goods, not just typical consumption goods consumed by urban households. It includes spending by households and non-profits, and generally reflects a more complete picture of consumer behavior and adjusts for changes in consumption patterns over time.The CPI has fewer goods and assumes fixed weights on prices. The PCE, alternatively, has more goods and changes the weights on prices as it updated the basket that it tracks.The CPI suffers from substitution bias, leading to overstatement in the cost of living, while the PCE does not. By substitution bias I mean that consumers may change their purchasing habits in response to changes in relative pricing; for example, if the price of hamburgers rises significantly, consumers may purchase more of a substitute product like hot dogs. By only tracking the price of hamburgers, one can overstate the actual cost of living and assumed inflation. By accounting for all goods, the PCE reflects how consumers may adjust spending through substitute products.
So, those are the general differences in the CPI and the PCE. You can likely see why the Feds prefers the PCE—generally more complete, tracks substituted expenditure, etc.
TLDR:
CPI = fewer goods, constant weights, measures cost of living, has substitution bias.
PCE = more goods, updates weights.
Hope you found that helpful! Here’s another article detailing nominal and real GDP (here), and one more about how to calculate inflation using multiple GDP deflators (here). Also:
Read about the Income Approach to GDP here.Read more economics stories here.To learn more about the oil market, consider reading about PADD Districts, the Why WTI and Brent are Crude Oils, and Why There are Price Differences Among Crude Oils, and my Oil & Gas Terms Guide.