What Is the Personal Consumption Expenditures Price Index?:
The Personal Consumption Expenditures Price Index, or PCE price index, is one of the primary government measures of consumer spending on goods and services in the U.S. Personal consumption is two-thirds of total household spending, and more than 70% of economic output, as measured by Gross Domestic Product (GDP). As such, it is the main workhorse that drives economic growth.
The PCE price index is used in three ways. First, it measures inflation trends. When the PCE price index rises, it indicates potential inflation. If the PCE price index were to fall, that would indicate potential deflation. (For more, see Types of Inflation)
Second, the PCE price index is used to find out how much households spend on consumption versus savings. Higher consumption levels translate directly into a greater GDP growth rate. However, a strong savings rate is good for long-term economic health. That's because savings can be used to fund bank loans for mortgages and business investments.
Third, the PCE price index is used to understand trends in the kinds of goods and services are being bought by households. This is a great way to find out how shopping patterns change in response to sharp price increases -- say, in gasoline each spring. In that way, the PCE price index can be used to determine whether the demand for various goods and services are elastic (demand falls as the price goes up) or inelastic (demand stays pretty much the same despite price increases).
How the PCE Price Index Is Calculated:
The Bureau of Economic Analysis (BEA) estimates the PCE price index each month. It uses the same data the creates the quarterly GDP report. However, this report measures production, and the PCE price index measures consumer purchases. How does the BEA convert the GDP report to the PCE price index?
First, the BEA estimates how much is being consumed based on the GDP data from suppliers. This includes manufacturers’ shipments, revenue for utilities, service receipts, and commissions for securities brokerage. Next, the it adds imports, subtracts exports and changes in inventory to determine the amount available for domestic consumption. This supply is allocated among domestic purchasers based on trade source data, Census data or household income surveys.
The last step involves converting the prices, which are still the producers' prices, to the end price paid by the consumer. The BEA bases the prices on the Consumer Price Index, or CPI, the most well-known measure of inflation. The CPI adds in the cost of profit margins, taxes and transportation costs. However, the PCE price index also includes estimates from other price sources, and so is a little more broadly based. The BEA includes data from the Census Bureau’s Economic Censuses, the monthly Retail Trade statistics, and BEA’s International Transactions Accounts, and various government agencies. For example, price for food that is grown and eaten on the farm are derived from the USDA. The dealer's margin for used cars and trucks is taken directly from the National Auto Dealers Association.
Since GDP comes out quarterly, and the PCE price index is estimated monthly, the BEA must estimate even further to fill in the gap. It does this using the monthly Retail Sales report. In addition, the BEA updates its calculations using data from the U.S. Census every ten years. (Source: BEA, Methodology Papers, NIPA Handbook: Concepts and Methods of the U.S. National Income and Product Accounts, Chapter 5: Personal Consumption Expenditures)
The PCE Price Index vs the CPI:
Whereas the PCE price index is based primarily on information from the GDP report and businesses, the CPI report is based on household surveys made by the Bureau of Labor Statistics (BLS). It surveys the 14,500 families, and the 23,000 businesses they frequent. Prices are collected for 80,000 consumer items. The CPI includes sales taxes, but not income taxes. For more on the CPI survey, go to the BLS website.
The PCE price index collects data on some different types of goods and services than the CPI does. For example, the PCE price index counts health care services paid for by employer-sponsored health insurance Medicare and Medicaid, while the CPI only counts medical services paid for directly by consumers.
Second, the PCE price index and the CPI use different types of formulas to calculate price changes. The formula used by CPI is more likely to report wide price swings in gasoline and computers, while the formula used to calculate the PCE price index is more likely to smooth out these price swings.
The Core PCE Price Index:
The BEA also provides a core measure of inflation with the PCE price index. This excludes volatile oil, gas and food prices. In fact, the core PCE price index is even less volatile than the core CPI. That's because of the ways they are calculated, as described above. (Source: Doug Short, Advisor Perspectives, Two Measures of Inflation: A New Update, April 13, 2012)
Why the PCE Price Index Is Important:
In January 2012, the Federal Reserve stated at its monthly FOMC meeting that it would use the PCE price index as its basic measure of inflation. If the core inflation rate is above the Fed's 2% target inflation rate for an extended period of time, then the Fed will take action to prevents inflation. It's first line of defense is raising the Fed funds rate, but it does have many other tools. The Fed uses the core inflation rate because food, oil and gas prices move so rapidly, especially in the spring and summer, and the Fed's tools take a long time to act.(Source: Federal Reserve Press Release, January 25, 2012)
Why the Core PCE Price Index Was Redefined:
In July 2009, the BEA redefined what was included in the core PCE price index. It now includes prices for restaurant meals and pet food. Even though these are still food items, the BEA reclassified restaurant meals under food services, and pet food under pets. The BEA considers the prices of restaurant meals and pet food to be less volatile than grocery store food prices. That's especially true of fresh vegetables that have to be trucked great distances and so vary with the price of oil and gas. The changing prices of pet food and restaurant meals are still reflective of true underlying inflation trends. Article updated July 24, 2014