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

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

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

1997 1998 1999 2000 2001 2002

Year

Infl

atio

n r

ate

(per

cen

t)

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=Dec20032000Q3 2.0% 1.7%2002Q1 1.2% 1.5%

Core PCE inflation rate, May 2002 and December 2003

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

1997 1998 1999 2000 2001 2002

Year

Infl

atio

n r

ate

(per

cen

t)

OBSERVED MAY 2002

OBSERVED DECEMBER 2003

Data revisions

• The Fed gets rid of the “unwelcome fall” language by May 2004. Revised data by August 2005 show Fed should have worried about an unwelcome rise in inflation

2000Q3 2002Q1v=May 2002 2.0% 1.2%v=Dec2003 1.7% 1.5%v=Aug2005 1.6% 1.8%

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

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

1997 1998 1999 2000 2001 2002

Year

Infl

atio

n r

ate

(per

cen

t)

AUGUST 2005

MAY 2002

DECEMBER 2003

Data revisions

• Policymakers need to understand revisions to inflation

Figure 5Four Quarter Inflation Rate in PPCEXInitial to August Revision and Actuals

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Date

Act

ual

s an

d R

evis

ion

s (p

erce

nt)

Revision

Initial

August

Figure 6

Revisions to Four Quarter Inflation Rate in PPCE and PPCEXInitial to August Revision

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Date

Rev

isio

ns

(per

cen

t)

PPCEX

PPCE

• 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