For most people, inflation is synonymous with rising prices. But for economists, it’s an indicator of how fast an economy is growing. When the costs of goods and services are rising too slowly, an economy could be at risk of recession. When they’re rising too quickly, it could be on the road to hyperinflation.
Today, there are two popular measures of inflation, and each tracks prices from a different perspective:
- The Consumer Price Index (CPI) tracks the change in out-of-pocket expenditures for goods and services by urban households only.
- The Personal Consumption Expenditures Index (PCE) tracks the change in expenditures on goods and services by all households, including those paid for on a consumer’s behalf, such as employer-sponsored health benefits.
Both measures come in stripped-down core versions that exclude volatile energy and food prices, and are more widely watched by economists. The Federal Reserve once used the core CPI as its primary inflation gauge but switched in 2000 to the core PCE, whose formula it believes better reflects changes in spending. So despite the core CPI increasing to more than 2% (the Fed’s stated inflation target for the U.S. economy) since November 2015, the core PCE hasn’t yet reached that level,1 which is one reason the Fed has been so cautious in boosting short-term interest rates. (See “A tale of two indexes,” below.)
A tale of two indexes
The core CPI has exceeded the Fed’s 2% inflation target, but the more closely watched core PCE has not.
Source: Federal Reserve of St. Louis and U.S. Bureau of Labor Statistics, 01/2006–12/2016.
That said, many economists expect inflation to inch higher over the next few years, and the Fed anticipates it will continue hiking rates through 2017. If rates don’t rise, that may signal that the Fed is content to let inflation run relatively hot in order to keep growth on track and to put deflation risk firmly in the rear-view mirror.
The bottom line: Both CPI and PCE measure the health of the economy, but follow the latter if you want to be on the same page as the Fed.
1U.S. Bureau of Economic Analysis, as of 03/01/2017.
What You Can Do Next
- If you’ve built a solid financial plan and a well-diversified portfolio, it’s best to ignore the noise and focus on your long-term goals. Want to talk about your portfolio? Call our investment professionals at 800-355-2162.
- Watch Schwab experts discuss other economic topics in the Schwab Market Snapshot.