Alternative Inflation Measures

Comparison: core vs. overall Overall measures: very volatile, especially because of food & energy shocks Core = excluding food & energy here; but research works on alternatives

Comparison across measures Examine GDP price index, PCE price index, CPI

Differences between measures Coverage (scope) –CPI: out of pocket spending of urban consumers –PCEPI: prices of all personal consumption expenditures in NIPA –GDPPI: price index of prices of all goods produced in economy (70% of which is in PCEPI)

Differences between measures Weights: –PCEPI and GDPPI: weights updated every quarter; based on business surveys (production measures) –CPI: weights updated every two years; based on household surveys (out-of-pocket expenditure measures)

Differences between measures Revisions: –PCEPI and GDPPI: revised as time passes to better reflect true weights across sample of businesses –CPI: never revised, except for seasonal adjustment

Differences between measures Bias: –PCEPI and GDPPI: small bias because of quality adjustment bias; around 0.5% for PCEPI and 0.4% for GDPPI –CPI: larger bias because of quality adjustment bias and substitution bias; at least 1.0%

Differences between measures Examples –Housing prices are 15% of PCEPI, but 32% of CPI (urban) –Medical prices are 20.5% of PCEPI, but only 6.2% of CPI (out of pocket)

GDPPI and PCEPI are revised; CPI is not That means the CPI is worse, not better Data revisions

Policy implications: the Fed could be confused by initial data, as it was in 2003 Data revisions

In 2000, Fed switched main variable for inflation to PCE price index (PCE inflation); in 2004 switched to PCE price index excluding food and energy prices (core PCE inflation); in 2007 it began using both Problem: these variables get revised Issue: are the revisions large enough to worry about?

Data Revisions May 2002: data show decline in core PCE inflation from 2.0% in 2000Q3 to 1.2% in 2002Q1 Academic research on deflation and the zero bound are fresh in policymakers’ minds

Core PCE inflation rate from 1997Q1 to 2002Q1, as observed May 2002

Data revisions Perhaps as a consequence of worry about low inflation, Fed drives real fed funds rate to negative levels for first time since early 1970s Fed adds phrase to FOMC statement that it worries about an “unwelcome fall in inflation” But: revised data by December 2003 show that inflation wasn’t declining after all v=May2002 v=Dec Q3 2.0% 1.7% 2002Q11.2% 1.5%

Core PCE inflation rate, May 2002 and December 2003

Data revisions The Fed gets rid of the “unwelcome fall” language by May Revised data by August 2005 show Fed should have worried about an unwelcome rise in inflation 2000Q3 2002Q1 v=May % 1.2% v=Dec % 1.5% v=Aug % 1.8%

Core PCE inflation rate, May 02, Dec 03, & Aug 05

Data revisions Policymakers need to understand revisions to inflation

The chained CPI uses chain weighting to improve on the overall CPI It works, but to do so, it must be revised Data are final after two years Revisions cause problems for changing payments, as in Social Security Chained CPI

Conclusions There is no perfect measure of inflation Fed uses multiple measures Using core inflation prevents overreaction to short-term shocks Fed should be aware of revisions The chained CPI is more accurate than the overall CPI