What is the best way to measure inflation?

There is more than one measure of inflation, so, which one should people pay attention to? The two main candidates are the Consumer Price Index (CPI) and the Personal Consumption Expenditures index (PCE). Which of the two is the better measure? And once that question is decided, is core inflation -- inflation with the effects of changes in food and energy prices removed -- better than an overall measure of inflation?

Which measure is best, the CPI or the PCE?

An Economic Letter from the Federal Reserve Bank of San Francisco describes the differences between the CPI and the PCE (which is denoted as PCEPI), and why the Fed prefers the PCE:

For most of its history, the Federal Reserve used the CPI to set policy and forecast inflation. However, in February 2000, the FOMC began using the PCEPI to frame its inflation forecasts.
The PCEPI and CPI share many of the same features. For example, the PCEPI, like the CPI, is designed to track the prices of goods and services consumed by households, and it includes much of the same data. However, the PCEPI differs from the CPI on many dimensions. The FOMC cited three of these as reasons for switching its focus from the CPI to the PCEPI (Board of Governors 2000). First, the PCEPI’s formula adjusts to changing consumption patterns, while the CPI is based on a basket of goods and services that is largely fixed. Second, the PCEPI is revised over time, allowing for inflation to be tracked as a more consistent series. Third, the PCEPI's larger scope of goods and services provides a more comprehensive picture of the nation's consumer spending than the CPI.

Thus, while the media tends to focus on the CPI, most economists believe that the PCE is a superior measure, and Fed watchers should certainly be paying more attention to the PCE than the CPI. However, as the Economic Letter notes, the two measures tend to converge over time, though there can be large differences at some points in time. For example, core CPI inflation is currently about a half a percentage point higher than core PCEPI inflation.

Is core inflation better than headline inflation?

Is it better to focus on overall PCE inflation or on core PCE inflation that removes the effects of food and energy prices? The answer depends upon the question being asked. If the question is, "What is the rate of change in the cost of living for a typical household?" the answer is overall PCE inflation. Households, of course, spend money on food and energy products, so any measure of the cost of living changes hitting households must include these goods.

But if the question is what will inflation be in the future -- which is what the Fed almost always wants to know due to lags in the effects of monetary policy -- core inflation is superior. Food and energy prices are highly variable over time, and that variability obscures the underlying trend rate of inflation. By removing these prices from the index, a much clearer picture of future inflation emerges.

Thus, there is no single answer to the question of which measure of inflation is best, particularly when the comparison is between core and overall inflation. It depends upon how the measure will be used.