The Federal Reserve has a dual mandate from Congress: stable prices and full employment.
For the first objective, what prices should the Fed keep stable? There are many to choose from. Although they’re obviously correlated, they do deviate from each other, especially in the short run.
The Fed and specifically the FOMC look at many price indexes, but their preferred measure is the personal consumption expenditures (PCE) price index. The inflation rate from this index is published monthly by the Bureau of Economic Analysis. Its advantage over the consumer price index (CPI) and the producer price index (PPI), for example, is that the PCE covers a broader set of household expenses.
Although monetary policy aims at price stability, it does not have an instantaneous effect on prices. Policy is believed to follow long and variable lags, on average, over a couple of years. So it’s really important to have a measure of prices that can be well predicted, as the FOMC is trying to influence future prices. For this reason, the FOMC primarily focuses on core PCE inflation. Core PCE inflation excludes food and energy because those two types of prices can fluctuate dramatically, because of seasonal factors or the high volatility of markets. Given the lags that the FOMC has to work with, this kind of volatility makes forecasting the path of prices much more difficult. And the FOMC is not in a position to react to short-term price fluctuations anyway.
The FRED graph above shows three series: core PCE inflation, PCE food inflation, and PCE energy inflation. It’s clear that core PCE is much more stable, while the other two fluctuate widely around it. One could modify this graph to show month-to-month inflation instead of year-to-year inflation, and that picture is even starker. In engineering parlance, the signal-to-noise ratio is much better with core PCE inflation.
How this graph was created: On FRED, find the release table for PCE price indexes by major type of product. Check the three series and click “Add to Graph.” Then click “Edit Graph,” choose units “Percent change from year ago,” and click “Apply to all.”
Suggested by Christian Zimmermann.