The CPI Is Important, But What Else Are Inflation-Watchers Watching?

Fourth Quarter 2022 | Global Macro Analysis Interest Rates Inflation Market Perspectives

The Consumer Price Index gets a lot of attention each month, but it's not the only game in town.

What You Need To Know

The Consumer Price Index’s monthly readings on inflation almost always move markets and influence Federal Reserve policies. But the CPI is sometimes viewed as untimely, limited in scope, and prone to subtle biases.
The Federal Reserve’s own preferred inflation-measuring tool is the Personal Consumption Expenditures Price Index, which derives most of its data from businesses and typically involves a broader array of tracked goods and services.
Other serious inflation-watchers prefer to track the Producer Price Index, which focuses on the prices of commodity goods making their way through the economic pipeline. Inflation breakevens are another favored inflation gauge.

When it comes to measuring inflation, investors and policymakers have a full menu of alphabet-soup metrics to choose from—the CPI, the PPI, the PCE, the GDP Index, and a host of others. But the Consumer Price Index (CPI)¹ typically grabs most of the headlines—and for good reason. From determining the size of next year’s Social Security checks to influencing the amount of interest that owners of Treasury Inflation-Protected Securities (TIPS)² will earn, time and time again, the monthly CPI print has moved markets and dictated the course of US monetary policy. But as a classic lagging indicator, the CPI has often been criticized for reflecting trends that are already out of date; critics also say it uses methodologies that may be prone to error or subtle biases (see the sidebar below for more on this).

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For the average consumer or casual investor, the so-called “headline” CPI number—the figure that also includes volatile food and energy prices—may be sufficiently revelatory. The August report, for example, showed that the annualized rate of inflation stood at 8.3%, slightly lower than July’s 8.5%. While the small statistical retreat was largely attributed to moderating energy costs, analysts zeroed in on underlying month-to-month price increases in the cost of food, new cars, housing, and electricity, and natural gas, which suggested to the Federal Reserve (Fed) and other stakeholders that inflation was (and is) still a thing.³

But many economists, investors, and other serious inflation-watchers, who hope to unearth trends that the CPI may overlook, will often train their focus on alternative inflation measures, which can sometimes provide a broader, more nuanced, view of the direction and timeliness of price movements. Let’s look at some of the more prominent alternative inflation measures.

Personal Consumption Expenditures Price Index (PCE)

Every two years, the Bureau of Labor Statistics (BLS) surveys a selection of consumers about their purchasing habits in order to create the CPI “market basket” of goods and services. The Commerce Department’s Personal Consumption Expenditures Price Index,⁴ by contrast, is based on quarterly data from businesses about customer purchases.⁵ Both indices are measuring price changes, but the PCE happens to be the Fed’s preferred inflation measure as it tries to achieve its target of 2% annual inflation.

The Fed prefers the PCE over the CPI for a number of reasons. For starters, the PCE has a broader scope than its CPI counterpart. Healthcare is a typical example. Whereas the CPI looks at out-of-pocket medical costs incurred at the point of service (e.g., pharmacy costs, co-pays, etc.), PCE data includes the costs of medical programs incurred by the government such as Medicare and Medicaid, as well as private-insurer expenses. These costs may be considered more important to the shaping of Fed policy since they provide a window into sources of inflation that work their way down to consumers but aren’t captured by CPI data.

And while the CPI formula is more likely to be affected by wide price swings for items such as computers and gasoline, the PCE calculations tend to smooth out the price swings and produce a less volatile inflation index than the CPI (see FIGURE 1).

Additionally, the PCE Index is more likely to accurately reflect consumers’ substitution behavior, which occurs when increases in the price of one product prompt consumers to buy something cheaper—chicken instead of beef, for example. Aggregate substitution behavior tends to understate the severity of inflation as consumers actively look for ways to save money. Finally, PCE data can be revised more extensively than the CPI, which can only be adjusted for seasonal factors and only for the previous five years.⁶

The annual inflation rate as measured by the PCE Index stood at 6.2% in August 2022. While that was a slowdown from 6.4% over the year through July, it was higher than the 6% that economists in a Bloomberg survey had expected. More concerning: Core PCE—which excludes food and energy—rose 4.9% over the year through August, suggesting that inflation still has room to run.⁷

FIGURE 1

Three Ways to Measure the Impact of Year-Over-Year Inflation
Price trends as reported by consumers (CPI), businesses (PCE), and commodity buyers (PPI)

The above chart tracks monthly annualized price changes between 9/1/20–8/31/22 for the Core CPI, the Core PCE, and the Core Producer Price Index (PPI), which measures the average change over time in the selling prices received by domestic producers for their output. Prices included in the PPI are from the first commercial transaction for many products and some services. Each of the indices shown above excludes volatile items such as food and energy prices. Source: Bloomberg and Hartford Funds.

Since commodity prices often take time to work down to retail level, the PPI is considered to be a leading indicator of inflation.

The Producer Price Index (PPI)

As the name implies, the Index tracks prices paid by manufacturers and wholesalers in nearly all domestic goods-producing industries: mining, manufacturing, agriculture, forestry, natural gas, construction, electricity, and scrap metals. Each month, over 100,000 price quotations are collected voluntarily from more than 25,000 businesses, making the PPI a good source of information for analysts who prefer using commodity prices as a proxy for inflation.⁸

^{Since commodity prices often take time to work their way down to the retail level, the PPI is widely considered to be a leading indicator of inflation and a major source of information for investors concerned with industry- or sector-specific performance. For businesses that find it difficult to pass on price increases to customers, commodity inflation can serve as a warning signal of lower business profits.}

^{Unadjusted August 2022 figures showed a monthly decrease in the annualized rate of producer-price inflation. Lower prices for diesel and jet fuel, chicken eggs, organic materials, and home heating oil helped fuel the decline. But a closer look at the month-to-month changes highlighted accelerating inflation within specific categories. For example: Prices for construction machinery, beverage materials, and electric power rose from July to August 2022.⁹}

US Treasury Breakeven Inflation Rate

Unlike the indices described above—each of which rely on price-data changes as reported by government agencies—the Treasury breakeven inflation rate is basically a simple math calculation that can be written on the back of an envelope and whose result can provide insight into future levels of inflation:

Breakeven inflation rate = (nominal Treasury yield) – (TIPS yield)

Now let’s plug in some real numbers. As of 10/7/22, a 10-year Treasury note yielded 3.88% while a 10-year TIPS note yielded 1.62%. Simple subtraction gives us a breakeven rate of 2.26%.

Translation: Current market participants expect inflation to average at least 2.26% over the next decade. It’s called a breakeven rate because if investors believe that inflation over the next 10 years will average around 2.26%, they’d be indifferent between owning a TIPS bond or a Treasury note. If an investor is convinced inflation may exceed the breakeven rate over 10 years, the TIPS bond starts to look like a better investment despite the apparent lower yield. That’s partly because TIPS bonds come with built-in inflation protection (i.e., payments indexed to the CPI). All things being equal, a TIPS bond held to maturity in an environment of rising inflation should exceed the breakeven rate.

The breakeven rate allows investors to focus on a single long-term number that potentially reflects the general consensus of future inflation within the financial markets.

But leaving the merits of TIPS investments aside, the breakeven rate (which has been volatile lately) is easy to calculate for a quick take on the inflation outlook. With the CPI currently running at an 8.3% annual rate and with a Fed clearly aiming to get “normal” inflation back to around 2% by 2023 or 2024, the breakeven rate allows investors to focus on a single, long-term number that reflects the general consensus of future inflation within the financial markets.

So, What's Up With the CPI?

Given its linkage to monetary and fiscal policy and to a host of public payment programs, the CPI tends to receive its fair share of scrutiny—and criticism. Here’s a brief summary of the CPI’s perceived shortcomings:

Underrepresented Spending Categories
The elderly population tends to rack up more bills for insured medical care than the population at large. Long-haul truckers earn their living by filling up their rigs with diesel while nearly everyone else uses gasoline. Rural residents spend more on feed supplies than on avocado toast. Yet the CPI tends to underweight these and other spending categories, and it covers what it calls “urban” consumers—roughly 93% of the US population—but most rural consumer spending isn’t included at all.

Backward-Looking and Sometimes Late
The prices reported by the CPI are taken from observations made in the previous month; even prices reported in the current month will be at least two to three weeks behind. Furthermore, the surveys of expenditure information provided by families and individuals on what they actually bought (as opposed to how much they paid), can take as long as two years or more to be updated to reflect shifting purchase patterns.

Housing costs are another area critics call problematic. Currently, the BLS measures two types of housing costs—rent paid to landlords and a rent proxy or “owners’ equivalent rent.” Together, these two measures account for nearly one-third of the overall CPI (see FIGURE 2). The problem is that data for each of the two components are only collected and updated every six months, so by the time the numbers are rolled into each month’s new CPI report, housing-cost inflation can surge ahead in ways that the CPI can’t always capture.

FIGURE 2
CPI Categories by Weight, August 2022

Group	Weight
Housing	32.2%
Commodities	21.2%
Food	13.5%
Energy	8.8%
Education	7.6%
Healthcare	6.8%
Transportation	5.9%
Other Expenses	4.0%
Total Expenses	100%

Source: Investopedia, 9/27/22

Substitution Bias
During times of rapid inflation, it’s natural for most consumers to pare back on expensive items and either make do without or find cheaper substitutes. For decades, the BLS ignored this behavior, likely overstating the true cost of living. In 1996, a major study commissioned by Congress prompted a series of methodology changes, and it’s been estimated that since then, the rise in the CPI only suffers from a 0.5% annual overstatement.¹⁰ Needless to say, critics still aren’t satisfied.

This addresses one reason the Fed is said to prefer using the PCE Index: The PCE can more easily switch to different baskets of goods from month to month to better account for substitution behaviors. By contrast, the CPI tends to use the same basket month after month.

Shrinkflation and Quality-Adjustment Bias
Supermarket shoppers may be all too familiar with a 2-ounce candy bar repackaged as a 1.8-ounce candy bar for the same price. That’s called shrinkflation: the per-ounce price increased by 11% in this example. Although the BLS insists that its inflation estimates take shrinkflation into account, not all CPI critics are convinced.

Quality adjustment is a related problem for the CPI, whose basket of goods and services is revised and updated over time—but sometimes misses major product improvements. Classic example: the VCR and personal computer were widely sold in the early 1980s but didn’t enter the CPI basket of goods until 1987. This can result in missing price declines—and overstated inflation prints.

For more information on how inflation can impact your portfolio, talk to your financial professional.

¹ The Consumer Price Index (CPI) is defined by the US Bureau of Labor Statistics as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services”.

² Treasury Inflation-Protected Securities (TIPS) are Treasury bonds that are adjusted to eliminate the effects of inflation on interest and principal payments, as measured by the Consumer Price Index.

³ The Personal Consumption Expenditures Price Index (PCE) is defined by the US Bureau of Economic Analysis as a measure of the prices that people living in the US, or those buying on their behalf, pay for goods and services. The index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

⁴ “Stubbornly High Rents, Food Prices Boost US Inflation in August”, Reuters, 9/13/22.

⁵ “Two Inflation Tales—Which Should We Believe?”, Marcus.com, 8/8/22.

⁶ “PCE and CPI: What’s the Difference?”, Callan.com, 9/22/22.

⁷ “The Fed’s Preferred Inflation Measure Remains Stubbornly High”, New York Times, 9/30/22.

⁸ “What Does the Producer Price Index Tell You?”, yahoo.com, 6/3/21.

⁹ “Producer Price Index News Release Summary”, bls.gov, 9/14/22.

¹⁰ “Shortcomings of the Consumer Price Index as a Measure of the Cost of Living”, lumenlearning.com; module 7.

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