Is Your Inflation Different?

For much of the last two decades, if inflation drew any mention from economists or central bankers, it was mostly to note how low it was. But after more than a year of accommodative fiscal and monetary policy in response to the COVID-19 pandemic, the conversation has shifted. Official inflation measures have ticked up in recent months to levels not seen in decades.

Under the Fed's new monetary policy framework announced last year, the Federal Open Market Committee (FOMC) has signaled a greater willingness to allow inflation moderately above its 2 percent long-run target for some time following a period of inflation below target. In the past, the Fed often acted to preempt a rise in inflation, but policymakers have indicated they will now wait to change interest rate policy until inflation pressures actually emerge in the data. (See "The Fed's New Framework," Econ Focus, First Quarter 2021.)

At a press conference following the April 27-28 FOMC meeting, Fed Chair Jerome Powell said that before increasing interest rates, "We want to see labor market conditions consistent with maximum employment, we want to see inflation at 2 percent, and we want to see it on track to exceed 2 percent."

But which inflation signals will Fed officials be watching? Inflation is typically defined as a generalized and sustained increase in prices across the economy. But prices rarely change evenly across all goods and services at the same time. Recently, for example, prices for lumber and used cars shot up due to supply constraints coupled with increasing demand. Moreover, households spend money on different things. That means an uptick in inflation in some products or services could affect households unevenly. Should central bankers take this into consideration when determining the appropriate stance for monetary policy?

Building an Inflation Index

Measuring inflation requires tracking what people buy as well as how much they pay for it. Doing that for every purchase across the entire economy is a daunting task for any researcher. Some U.S. economists experimented with creating price indexes for a limited set of goods in the 19th century. The federal government became involved in tracking prices following the creation of the Bureau of Labor Statistics (BLS), then called the Bureau of Labor, in 1884.

According to a 2014 history by BLS economist Darren Rippy, the BLS first started working on a cost-of-living index for families by studying expenditures and retail prices from 1888 through 1890. At the turn of the 20th century, presidents increasingly called upon the BLS to mediate labor disputes between industry and union leaders and to track price changes during the two world wars. This work ultimately led to the creation of the Consumer Price Index, or CPI.

Although the methodology behind the CPI has evolved over the decades, the BLS's fundamental approach has remained the same. It surveys households about the goods and services they buy and collects data on prices using both surveys and on-the-ground research. Using this data, the BLS constructs a "market basket" of goods and services intended to capture the consumption patterns of the average urban household. Goods and services are lumped into one of eight large groups and receive weights based on their share of the typical household budget. Price changes for goods and services that account for a larger share of household spending carry more weight in the overall CPI measure of inflation.

Over time, the CPI has become the most widely used and cited benchmark for inflation in the U.S. economy. Firms look at it when making decisions about adjusting their prices and wages. And the federal government uses the CPI to make cost-of-living adjustments to welfare programs like Social Security as well as to update tax brackets.

That said, the CPI has limitations, which have prompted the development of other price indexes. The basket of goods that households purchase is not static. Consumers respond to price increases in some goods by substituting cheaper alternatives. For example, if the price of beef goes up, households might buy less beef and more chicken. The BLS does periodically update its market basket, but on a lag, meaning the CPI doesn't capture substitutions like these until long after the fact. For instance, from the end of 2017 through the end of 2019, the BLS used consumer survey data collected in 2015 and 2016.

This can result in mismeasurement when consumption habits are changing rapidly. A 2020 paper by Alberto Cavallo of Harvard University found that the CPI underestimated inflation during the COVID-19 lockdown. That is because households spent more on things like food, which experienced inflation, and less on fuel and transportation, which experienced deflation. Cavallo estimated that because of these changes in household consumption, actual inflation in the United States in September 2020 was 1.9 percent, compared to 1.4 percent according to the CPI.

Other inflation measures, like the Personal Consumption Expenditures (PCE) price index released by the Bureau of Economic Analysis, attempt to account for consumer substitutions when constructing their market basket. The PCE also applies different weights to goods and services than the CPI.

Both the CPI and PCE also have "core" measures of inflation, which strip out price changes for food and fuel. While both of those categories make up an important part of many households' budgets, their prices tend to be more volatile in the short run. Their inclusion in price indexes can muddy the long-run inflation signal, which matters for institutions like the Fed tasked with keeping long-run prices stable. For these reasons, the Fed has used core PCE as its benchmark measure of inflation since 2000.

What Do Households Experience?

The goal of inflation indexes like the CPI and PCE is to produce a single measure of inflation for the whole economy. To do that, researchers attempt to capture changes in the cost of living experienced by the average household. It should come as no surprise, then, that the experiences of many households deviate from that average.

Households spend money on different things and pay different prices for the same types of goods and services. The BLS Consumer Expenditure Survey, which tracks households' spending by income and other demographic characteristics, shows that low-income households spend a greater share of their income on core needs — housing, food, and transportation — than higher-income households. Household spending and income also vary considerably by age. People spend a greater share of their income on health care as they age. Prices for both medical care and education have been rising more rapidly than prices for goods and services generally. As a result of these and other consumption differences, any given household could be experiencing inflation that is very different from the CPI or PCE numbers. Indeed, the BLS has constructed an experimental CPI for older Americans, which shows they tend to experience higher inflation. (See chart below.)