The Federal Open Market Committee (FOMC), the decision-making arm of the U.S. Federal Reserve (Fed), adjusts interest rates to help keep inflation near a 2% target. The FOMC's preferred measure of inflation is the Price Index for Personal Consumption Expenditures (PCE), primarily because it covers a broad range of prices and picks up shifts in consumer behavior. The Fed also focuses on core inflation measures, which strip out volatile food and energy categories that are less likely to respond to monetary policy.
The typical American might be more familiar with the Consumer Price Index (CPI), which was the Fed's favorite inflation gauge until 2012. A subset of the broader index, called the Consumer Price Index for All Urban Consumers (CPI-U), is used to determine cost-of-living adjustments for federal income taxes and Social Security.
The CPI only measures the prices that consumers actually pay for a fixed basket of goods, whereas the PCE tracks the prices of everything that is consumed, regardless of who pays. For example, the CPI includes a patient's out-of-pocket costs for a doctor's visit, while the PCE considers the total charge billed to insurance companies, the government and the patient.
Another difference is in the ways the indexes track expenditures over time. The PCE uses current and past spending to capture consumers' tendency to substitute less expensive goods for more expensive items. By contrast, the weighting of CPI categories is adjusted every two years, so the index does not respond quickly to changes in consumer spending habits. It nevertheless provides a good comparison of prices over time.
According to the CPI, inflation rose 2.1% in 2016 — in line with the 20-year average of 2.13% and the Fed’s current target.1 This level of inflation may not seem like a big strain on the family budget, but even moderate inflation can have a negative impact on overall purchasing power. In addition, inflation can reduce the real returns of investments over time, so it’s another factor to consider when planning for investing goals.
Of course, if inflation picks up speed, it could become a more pressing concern for consumers and investors.
1 U.S. Bureau of Labor Statistics, 2017 (data through December 2016)
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