Measuring Inflation: CPI and PCE

Why this matters

A price index turns millions of individual prices into one number, and that number does real work. The principal of a TIPS bond is adjusted using the CPI,¹ the Federal Reserve's 2% goal is defined with the PCE price index,² and every "real" return in this course subtracts one of them. The choices made in building an index, about what to include, how to weight it, and how to handle better products, change the answer by enough to matter over a few decades.

How the CPI is built

Each month BLS records the prices of about 80,000 items, classified into more than 200 categories.³ The main index, the CPI-U, covers urban consumers, who make up over 90% of the US population. A narrower version, the CPI-W, covers households of wage earners and clerical workers, about 30% of the population.³

Prices are combined using spending weights from the Consumer Expenditure Surveys, which ask households what they buy. Since 2023, BLS has updated the weights every year, using spending from two years earlier.⁴ An item's weight, called its relative importance, is its share of total spending in the index.

Bureau of Labor Statistics figures.⁵ Services make up most of the index, and shelter alone is more than a third. Food and energy together are about a fifth.

From weights to the headline

Because the index is a weighted average, each component's contribution to inflation is roughly its weight times its own price change.

Contribution ≈ Weight × Price change of the component

Component	Weight	Price change	Contribution
Shelter	35.6%	+3.0%	+1.07 points
Other services	25.1%	+3.5%	+0.88 points
Goods other than food and energy	19.2%	+1.0%	+0.19 points
Food	13.7%	+2.5%	+0.34 points
Energy	6.4%	−10.0%	−0.64 points
All items	100%		+1.84%

A 10% fall in energy prices takes only about 0.6 point off the total, while a modest 3% rise in shelter adds more than a point. The weights shift a little as relative prices change, so this is an approximation.

Housing: the biggest and slowest part

The CPI doesn't price owned homes. BLS treats a house as a capital, or investment, good, separate from the shelter it provides, and measures the cost of that shelter as owners' equivalent rent: what the home would rent for.⁶ House prices themselves aren't in the index.

Both rent and owners' equivalent rent come from a survey of rental units. Each unit in the sample is priced every six months, and the monthly change is worked out from the six-month change. Many rents are locked in for the length of a lease.⁶ The result is that shelter inflation in the CPI moves slowly and late.

Bureau of Labor Statistics figures.⁷ Headline inflation peaked in June 2022. Shelter kept climbing for nine more months and peaked in March 2023, by which time headline inflation had fallen to 5%. Because each unit is repriced only every six months and many rents are fixed for a lease, a change in rents for new leases reaches the index gradually.

Better products and changing habits

Quality change

When an item in the sample is replaced by a newer model, part of any price difference may be paying for a better product. BLS adjusts for this, in some cases with statistical analysis of how much each feature is worth.³

Old model's price	$1,000
New model's price	$1,050
Estimated value of the improvements	$40
Price change counted	$10, or 1%

Without the adjustment, the index would record a 5% rise for something that is partly a better machine. The size of the adjustment rests on an estimate, which is one reason measured inflation is never exact.

Substitution and the chained CPI

The regular CPI prices a fixed basket. When one item gets expensive, people often buy less of it and more of something similar, and a fixed basket misses that switch, so it can overstate the rise in the cost of keeping the same standard of living. BLS publishes a chained CPI, the C-CPI-U, that allows for substitution across categories. Its final figures need spending data that aren't available until 10 to 12 months after the month they describe.³

Over long periods the gap adds up. From December 1999 to December 2024, the CPI-U rose 87.5%, about 2.55% a year, while the chained CPI rose 75.2%, about 2.27% a year.⁸

CPI and PCE: four differences

The PCE price index, from BEA, measures prices across personal consumption expenditures in the national accounts. A BEA study comparing the two found four sources of difference:⁹

• Formula. The CPI uses a modified Laspeyres formula, which works from a fixed basket. The PCE price index uses a Fisher-Ideal formula, which uses spending patterns from both periods it compares, so it allows for substitution.
• Weights. CPI weights come mainly from household surveys, PCE weights mainly from business surveys. Housing is the biggest difference: at the time of the study, rent of shelter was about 32% of the CPI and about 15% of the PCE index.
• Scope. The CPI covers what urban households pay out of pocket. The PCE index also covers spending made on households' behalf, such as medical care paid for by employer health insurance or by Medicare and Medicaid.
• Other. Smaller differences in seasonal adjustment and in the prices used.

From 2002 to mid-2007, the period studied, the CPI rose about 0.4 percentage point a year faster than the PCE index, and the formula difference explained almost half of the gap.⁹ The gap has held over longer periods. From December 1999 to December 2024, the CPI rose about 2.56% a year and the PCE index about 2.19%. For the core measures, without food and energy, the figures were 2.40% and 2.09%.¹⁰¹¹¹² It isn't a fixed rule, though: over the 12 months to August 2026, core PCE rose faster than core CPI, as Reading Economic Data Releases showed.

Which index to use

Each index answers a slightly different question, and the right one depends on the use.

When you compare an investment's return with inflation, the choice of index can move the answer by a few tenths of a point a year, and over 25 years that compounds into a real difference: 87.5% against 75.2% for the two versions of the CPI alone.

Key takeaways

• The CPI tracks about 80,000 prices a month, weighted by household spending from two years earlier, updated yearly.
• A component's contribution to inflation is roughly its weight times its price change. Shelter is over a third of the CPI.
• Housing enters as rent and owners' equivalent rent, which move slowly. Shelter inflation peaked nine months after the headline in 2023.
• Quality adjustment removes the part of a price rise that pays for a better product. The chained CPI allows for substitution and rises more slowly.
• The PCE price index differs from the CPI in formula, weights, and scope, and has usually risen about 0.3 to 0.4 point a year less.
• The Fed targets PCE inflation. TIPS are adjusted with the CPI-U.

Check your understanding

Energy is about 6.4% of the CPI. If energy prices rise 15% over a year and nothing else changes, roughly how much does that add to 12-month CPI inflation?

1. About 1 percentage point, 15% times a 6.4% weight.
2. About 15 points, since energy prices rose by 15%.
3. About 6.4 points, since that is energy's share.

Why has the chained CPI usually risen more slowly than the regular CPI?

1. It leaves out food and energy, the most volatile prices.
2. It covers only wage earners, who buy cheaper goods.
3. It allows for people switching away from pricier goods.

What's next

Measuring inflation is one question. Explaining it is another. What Drives Inflation looks at the causes: demand, supply shocks, money, and expectations.