Content area
Full Text
The Federal Reserve recently announced it will begin to release quarterly inflation forecasts based on the Personal Consumption Expenditure Price Index. As Chairman Bernanke said, the PCE index is generally thought to be "the single most comprehensive and theoretically compelling measure of consumer prices." At the same time, Bernanke said that "no single measure of inflation is perfect, and the Committee will continue to monitor a range of measures when forming its view about inflation prospects."
Another inflation measure the FOMC will continue to watch closely is the Consumer Price Index. The CPI is better known to the public than the PCE price index, and many contracts and government programs are indexed to it. Both the CPI and the PCE index are important gauges of consumer inflation for policymakers and analysts concerned with price stability.
The public and private sectors alike will want to be able to convert CPI inflation forecasts released by various organizations to PCE inflation forecasts, and vice versa. If the overall and core differentials between PCE and CPI inflation never changed, converting from one measure to the other would be as simple as converting temperatures from Celsius into Fahrenheit. But the inflation differentials can change significantly over time. For example, the overall inflation differential for the five years ending in mid-2002 fell from 0.6 percentage point to half that level over the next five years. At the same time, the core inflation differential fell even more sharply, from 0.74 to 0.05 percentage point.
To convert between CPI and PCE inflation projections, economists must construct statistical models to explain and predict the inflation differentials (overall and core), recognizing that the differentials may change over time. Based on the results in this article, a simple conversion factor tells us that core CPI inflation is about 0.3 percentage point higher than core PCE inflation. Using this core inflation differential, it is easy to convert the midpoint of the FOMCs central tendency for 2008 core PCE inflation of 1.8 percent to a core CPI inflation projection of 2.1 percent. Analogously, overall CPI inflation is about 0.4 percentage point higher than overall PCE inflation.
Such conversion factors should be reassessed periodically as economic conditions change and new inflation data become available. This article estimates a set...