Question

August 2017 was the sixty-fourth consecutive month that the rate of inflation as measured by the core personal consumption expenditures (PCE) price index was below the Federal Reserve's target of 2 percent. a. Briefly explain why using the consumer price index (CPI) might yield a rate of inflation different from that found using the core PCE price index. b. Explain how the choice of the price index the Federal Reserve uses to measure inflation can affect monetary policy.

Short answer

The CPI may yield a different inflation rate than the Core PCE because it includes more volatile prices and uses a fixed basket of goods, while the Core PCE excludes volatile prices and accounts for substitution. The choice of inflation measure can impact monetary policy by influencing the Fed's decisions on when to start contractionary or expansionary policies, influenced by the different inflation rates they reflect.

Step-by-step solution

Understanding Core PCE and CPI

To start, one must explain that both these indices are measures of inflation or deflation, just calculated differently. The core personal consumption expenditures (PCE) price index excludes volatile food and energy prices and is used by the Federal Reserve for inflation targeting, while the consumer price index (CPI) is an average measure of prices a household pays for a market basket of consumer goods and services, including food and energy.

Differences between the indices

CPI might yield a different rate of inflation than that found using the core PCE because of two main reasons. Firstly, the CPI includes food and energy prices which are volatile and can have short-lived changes. Secondly, it uses a fixed basket of goods for comparison over time, whereas the PCE index allows for substitution of goods as relative prices change.

Impact on Monetary Policy

In this context, it is crucial to explain that the choice of the price index by the Federal Reserve can have an impact on monetary policy, as the indices might reflect different inflation rates. For example, a higher inflation rate might make the Federal Reserve start contractionary monetary policies sooner than it would have with a lower inflation rate indicated by a different index. Also, PCE is preferred by the Federal Reserve partially because it accounts for changes in consumer behavior as relative prices change, which is not captured by CPI.

Key concepts

Understanding Core Personal Consumption Expenditures (PCE)

Inflation measurement is crucial for evaluating the economic health of a nation, and the Core Personal Consumption Expenditures (PCE) serves as a pivotal gauge for the United States. Unlike the more widely known Consumer Price Index (CPI), the core PCE price index narrows its focus, deliberately excluding the prices of food and energy due to their volatile nature. These items tend to fluctuate significantly due to factors like weather events and international politics, which can distort the true picture of inflation.

The core PCE reflects how much consumers are spending on goods and services, sans food and energy, and over time it captures shifts in consumer behavior as they substitute cheaper goods for more expensive ones. For instance, if the price of beef escalates, consumers might switch to chicken, and the core PCE would capture this substitution effect. Moreover, the core PCE is adjusted for the changes in the quality of goods and services, thus offering a nuanced picture of inflation and consumer behavior.

Deciphering the Consumer Price Index (CPI)

On the flip side, the Consumer Price Index (CPI) communicates the average change over time in the prices paid by urban consumers for a basket of goods and services. The basket is comprehensive, encapsulating everyday items like food, clothing, transportation, and medical services, and includes the volatile food and energy sectors. Unlike the core PCE, the CPI calculates inflation based on a fixed basket of goods without accounting for the substitution consumers might make in response to changing prices.

This method can lead to different inflation rates than those found with the core PCE. For example, if there is a sharp increase in gasoline prices, it would be immediately reflected in the CPI, potentially indicating a transient surge in inflation that might not be as pronounced in the core PCE. Consequently, these divergences in measurement are crucial for analysts, policymakers, and students to understand when they’re studying the dynamics of inflation.

Monetary Policy Primer

Monetary policy remains a fundamental tool used by central banks, such as the Federal Reserve, to control the money supply and interest rates in an economy. It’s designed to achieve a range of macroeconomic objectives which can include controlling inflation, managing employment levels, and maintaining currency stability. Changes in monetary policy can influence economic activities such as spending, saving, borrowing, and investment.

For instance, to curb high inflation, the Federal Reserve might implement contractionary monetary policy, raising interest rates to make borrowing more expensive and reduce spending. Conversely, if the economy needs a boost, an expansionary policy may be adopted, lowering interest rates to encourage borrowing and spending. The decision-making process around these policies relies heavily on accurate inflation measures like the core PCE and CPI.

Inflation Targeting Explored

Inflation targeting is a strategy used by central banks to anchor economic expectations by defining and publicizing a target inflation rate. The Federal Reserve, for example, aims for a 2 percent inflation rate, as they believe this rate fosters price stability and maximum employment over the long term. Reaching this target plays a pivotal role in maintaining the economy’s equilibrium.

However, the inflation measure a central bank chooses to track—be it the CPI or the core PCE—affects how it perceives pricing pressures within the economy and hence influences its monetary policy decisions. Opting for the core PCE, which often runs cooler than the CPI, could lead to a more patient approach in adjusting interest rates. Conversely, a central bank using CPI might react to short-term price spikes in food and energy with more immediate policy changes. Students should appreciate that these different measures and target practices impact everything from consumer interest rates to the broader economy.