Alternative indicators of inflation

Price stability is achieved, according to some definitions, when inflation is not a factor in the decisionmaking processes of households and businesses. Because of difficulties in measuring the aggregate price level, however, price stability does not necessarily imply achieving a constant level for a specific price index. All statistical measures of inflation are flawed.(3) And, there is no consensus on which of many imperfect measures to "stabilize." As a result, policymakers look at a variety of inflation indicators in gauging progress toward price stability. These indexes differ according to how they are calculated and according to the goods and services they cover.

The consumer price index (CPI) measures the average change in the price of a fixed market basket of goods and services purchased by consumers. The market basket is composed of seven major categories of expenditures--food, housing, apparel, transportation, medical care, entertainment, and other goods and services. Goods and services included in the index may be domestically produced or imported.

The producer price index (PPI) measures average changes in selling prices received by domestic producers of goods. The index is classified by stage of processing, with separate measures for finished goods, intermediate goods, and crude materials. Of all the PPI indexes, e PPI for finished goods is the most closely watched and the one that is cited in this article. The PPI measures prices at the first level of commercial transaction. Therefore, the PPI can sometimes serve as an indicator of future changes in broader measures of the general price level, such as the CPI. But because the PPI excludes services, its use as an indicator of consumer price inflation is limited.

Removing the food and energy components from the CPI and PPI sometimes gives a better indication of the underlying or core inflation rate. Food and energy prices are volatile and not always representative of economywide fundamentals. For example, when a drought raises food prices or OPEC raises oil prices, the effect on inflation is temporary. Looking at the CPI or PPI net of food and energy prices in such a situation can give a better indication of underlying inflationary pressure.

The GDP-based indicators of inflation measure average price changes for all goods and services produced in the United States, including investment goods and exports, but excluding imports. While the implicit GDP deflator allows changes in consumer and business spending patterns from one quarter to the next, the fixed-weight GDP deflator--like the CPI and PPI--holds spending patterns constant. The GDP-based inflation measures are derived from the same raw data as the CPI and PPI. Therefore, they potentially suffer the same quality-adjustment biases as the CPI and PPI.

Copyright Federal Reserve Bank of Kansas City First Quarter 1995
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