Although consumers don’t look forward to higher prices, moderate inflation is a sign of a healthy, growing economy. In fact, low inflation is one reason the Federal Reserve was slow to raise the federal funds rate even as the economy showed other signs of recovering after the recession. The Fed typically uses higher rates to curb inflation, just as it uses low rates to stimulate economic activity and employment.
The Fed’s current effort to gradually raise interest rates reflects a belief that the employment picture is solid and inflation is trending toward the central bank’s target rate of 2%.1 You may hear more about inflation over the next few years, so it might be helpful to understand how rising prices are measured.
CPI vs. PCE
The measure most often mentioned in the media is the Consumer Price Index (CPI), which tracks prices for a fixed basket of goods and services. Because the weighting of CPI categories is only adjusted every two years, the index does not respond quickly to changes in consumer spending habits, but does provide a good comparison of prices over time. 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 Fed’s preferred measure of inflation is the Price Index for Personal Consumption Expenditures (PCE), which tracks a broader range of expenditures and includes spending on behalf of consumers, such as medical expenses paid by employers, insurance companies, and government programs. The PCE tends to run lower than the CPI and uses current and past expenditures to reflect changes in consumer choices. The Fed focuses more specifically on “core PCE,” which strips out volatile food and energy categories that are less likely to respond to monetary policy.
Moderate inflation may not be a big strain on the family budget as long as income keeps pace with prices. For retirees living on a fixed income, however, inflation can cut significantly into the purchasing power of retirement savings. Whether you’re preparing to retire or already retired, you may want to keep an eye on inflation and be sure that your financial strategy accounts for rising prices.
1) Federal Reserve, 2016