Examining Contributions to Core Consumer Inflation Measures

Abstract

Abstract: The purpose of this paper is to examine the composition of inflation over time. The authors calculate the contributions to inflation for individual series of the consumer price index (CPI) and personal consumption expenditures price index (PCEPI) and then aggregate those contributions into major consumer expenditure categories. This technique provides a wealth of information concerning aggregate inflation behavior in a concise way, enabling the authors to describe the composition of inflation at any point in time. A particularly important benefit of this method is that it allows them to distinguish broad-based changes in inflation from changes due to relative price movements of a few components. The authors examine long-term trends in contributions to PCEPI core inflation and make inferences about the direction of inflation in the near term. In addition, they examine the decline in CPI core inflation over the 2002-03 period and find that the decline was largely driven by relative price changes of two components. JEL classification: C43, E31 Key words: CPI, consumer price index, PCE price index, inflation, prices Introduction Recent declines in U.S. core inflation measures have prompted a renewed effort to understand inflation dynamics. Since late 2001, core consumer inflation rates have declined to levels not seen since the early 1960s. Core inflation as measured by the consumer price index (CPI) declined to 1.1 percent (year-over-year) by the end of 2003 while the core personal consumption expenditures price index (PCEPI) moved below 1 percent. This decline in measured inflation rates, coupled with uncertainty about future demand conditions, generated concern and debate among analysts and policymakers about near-term inflation prospects. That concern was reflected in the May 2003 Federal Open Market Committee (FOMC) statement: ... the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. As core consumer inflation rates have edged lower, an increasing and probably undue amount of attention is being placed on the most recent observation. An aggregate inflation rate is limited in the information it provides, especially with regard to the sources of its movements. It is generally difficult to know whether changes in aggregate inflation result from broad-based price changes or from price changes in only a few components. There may be instances in which significant but otherwise idiosyncratic relative price changes among a few underlying components drive movements in the aggregate inflation rate for a sustained period of time. Analysts often attempt to confront this issue by looking at price changes of major components and making inferences about the impact of those changes on the aggregate inflation rate. However, these inferences are imprecise and do not provide a complete accounting of aggregate inflation. A more rigorous approach is to provide a precise decomposition of the inflation rate. In this paper we take the latter, more rigorous approach. We calculate and plot the percentage point contributions of major consumer expenditure categories to core inflation measures over time. This technique provides a wealth of information concerning aggregate inflation behavior in a concise way, enabling us to describe the composition of inflation at any point in time. By highlighting the composition of aggregate inflation, we gain greater insight into the underlying trends in inflation and are able to make more informed inferences about the direction of inflation in the near term. A particularly important benefit of this method is that it allows us to distinguish broad-based changes in inflation from changes due to relative price movements of a few components. Using this approach to examine long-run trends in core inflation, our analysis finds that the primary contributor to core inflation over the last two decades has been core services. …