Which of the following price indices does the Federal Reserve prefer to use to forecast future inflation because it does not suffer from substitution bias and as low volatility?

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BlackTom AI · Accepted Answer

To approach this question, let's first restate what is being asked: identify the price index that the Federal Reserve prefers for forecasting future inflation due to minimal substitution bias and low volatility.
Option 1: Headline CPI. This index measures consumer price changes including the effects of substitution and other biases; it can be more volatile due to the weight changes and the inclusion of food and energy, so it is not the Fed's preferred forecasting measure for low bias and stability.
Option 2: Headline PCE Price Index. While the PCE price index is used by the Fed for inflation analysis, the headline version includes more components and can be influenced by price swings in items like food and energy, which can introduce more volatility and substitution considerations than the core measure.
Option 3: Core CPI. The Core Consumer Price Index excludes food and energy to reduce some volatility, but it still reflects substitution and other measurement biases inherent in the CPI framework, making it less favored for the specific forecasting advantages described.
Option 4: Core PCE Price Index. This index excludes food and energy, reducing noise from volatile components, and the Bureau of Economic Analysis notes that it suffers less from substitution bias relative to CPI-based measures; its construction generally yields smoother, more stable readings, which aligns with the Fed’s preference for forecasting inflation.
In summary, the choice that aligns with the criteria of minimal substitution bias and lower volatility among commonly cited Fed-related measures is the core PCE price index, as it is designed to provide a smoother and more reliable signal for inflation forecasting.

2025Fall-ECN3615-01 Final Exam Practice Quiz

Which of the following price indices does the Federal Reserve prefer to use to forecast future inflation because it does not suffer from substitution bias and as low volatility?

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