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# How To Calculate Inflation Rate From CPI And PCE

Updated: Aug. 24, 2022

Inflation is the increase in the monthly price of a basket of consumer goods and services and it is tracked and calculated by two different bureaus of the US government. Learn the two ways inflation is calculated and how they differ.

## Inflation Basics

Inflation is essentially the difference in the price of consumer goods and services over a period time. It is tracked each month and reported as an annualized number. A representative basket of goods and services is used for the calculation and it is kept constant over time except for occasional changes to reflect long-term modifications in consumer buying patterns. It is also defined such that it reflects the average change in prices over multiple regions across the United States. Inflation is also measured and reported by most other countries.

## How Is Inflation Calculated?

Two separate bureaus of the U.S. federal government track inflation - the Bureau of Labor Statistics (BLS) and the Bureau of Economic Analysis (BEA). While they both aim to represent the same concept and use similar methodologies, their data is slightly different, so their calculations can be slightly different as well.

• CPI: The BLS calculates Consumer Price Index (CPI) inflation by tracking what Americans are actually buying. It surveys some 24,000 consumers every quarter and draws additional data from 12,000 more who keep annual diaries of their purchases.
• PCE: In contrast, the BEA calculates Personal Consumption Expenditure (PCE) inflation, which pulls its data from the companies that sell the products instead.
• PPI: The BLS also tracks data on the prices of consumer goods taken from their initial commercial transaction. That means it measures prices further up the production chain than the PCE, which tracks the last transaction in the chain - the one to the end consumer.

Source: Forbes

## CPI Inflation Rate Formula

It may sound like CPI and PCE are essentially the same, but some things do differ between them. Substitution, for example, is not generally reflected in the CPI calculation. That's when the rising price of say a food item causes people to substitute another food item. This can affect the supply and demand equilibriums for the two items.

Another difference between CPI and PCE approaches is the inclusion of indirect costs. Some consumer goods and services are not purchased directly by the consumers themselves. One example is medical costs, which are frequently paid for by healthcare insurance.

The table below compares CPI to PCE approaches to calculating inflation.

 CPI PCE Origin BLS BEA Methodology Data on the same basket of goods & services tracked monthly and annualized Data on the same basket of goods & services tracked monthly and annualized Data Source Consumers Businesses Substitution Not reflected in CPI Reflected in PCE Indirect expenses Not reflected in CPI Reflected in PCE

## Finding Inflation Rate With PCE

Since the PCE approach to inflation looks at what businesses sell specified goods and services for, the PCE approach can be extended in concept to all the goods and services sold in the US and that by definition is the gross domestic product (GDP). Therefore, yet another way to calculate inflation is from the GDP.

This is accomplished by comparing the nominal GDP to the Real GDP for the same period. Nominal GDP is the actual sum of all goods and services, whereas Real GDP is essentially the after-inflation version. When you divide Nominal GDP by Real GDP, you get a ratio that, when multiplied by 100, gives you the GDP "deflator", an inflation rate indexed back to a preselected base year.

## What Does Inflation Mean for the Workforce?

Since inflation is a measure of how much prices increase for the goods and services consumers buy each year, it is of concern to consumers with regard to their wages. While a certain amount of inflation (albeit a relatively low amount like 1-2%) is a characteristic of a healthy functioning economy, consumers expect that their wages will increase by at least that amount to preserve their purchasing power.

Many employers, labor unions, and government entities watch the inflation rate closely and consider it a part of their wage calculations each year. Some will guarantee employees a wage increase at least equal to the inflation rate each year.

## What Does Inflation Mean for Investors?

Investors expect their assets to grow each year by an amount that compensates them for both inflation and the "risk premium" of the investment. The risk premium is the amount of return an investor requires for the financial risk inherent in the investment. When inflation increases, investors will want more return from their investments in return, though it is not something investors can count on always getting.

## How Inflation Impact Monetary Policy

The Fed monitors inflation as part of its monetary policy. While inflation isn't the only goal of monetary policy, it is an important one. The fed will generally want to have a slow, steady rate of inflation in the economy. Too high an inflation rate can potentially overheat the economy and lead to runaway inflation. Negative inflation, or deflation, is not desirable either. Therefore the Fed uses its monetary policies, such as setting bank reserve rates and short-term interest rates, to keep inflation at a low steady level.

## What is the Current Inflation Outlook?

The inflation rate as of January 31, 2022 was 7.48%, the highest monthly reading since February 1982. The number for Jan 2021 was only 1.4% and for Jan 2020 was only 0.99%.

 Time Interest Rate January 2022 7.48% January 2021 1.4% January 2020 0.99%

The outlook will vary extensively depending on your source, especially after the recent spike at a 40-year high. A major contributor to recent inflation appears to be the supply-chain disruptions caused by the pandemic, which caused many items to increase in price. It is widely expected that inflation will recede somewhat as the supply chain returns to its normal functioning, but there is no guarantee of when that might be. In addition, new COVID-19 variants threaten to extend the pandemic as well, causing yet more uncertainty.

Tip: While inflation is a concern, it isn't something you will have any control over, and knowing exactly what the level of inflation will be for the next year or two is not as critical as planning for some level of inflation, even if it turns out to be wrong by a few percent. With inflation running north of 7%, it's time to build it into your thinking with regard to purchases, wages, and realigning your investments.

## Bottom Line

Inflation is back on everyone's mind in 2022 after a multi-decade hiatus and it has consumers, employers, investors, and the Fed all concerned. There is little we can do to change it, so the best path forward is to plan for it in purchases, investments, and wages.