One widely employed tool for helping to do so is known as inflation targeting, whereby a central bank sets a numeric goal for inflation. Once this target is publicly stated, the bank can be held accountable for its actions in regard to meeting, or not meeting, this target. Countries that have adopted such a tool have generally had a favorable experience, and there is evidence that inflation targeting is correlated with increased stability in output growth, lower inflation, and more stable inflation expectations (Dotsey, 2006).

While at a broad level the idea of inflation targeting can appear to be a straightforward concept, carrying it out in practice requires a central bank to make many subtle decisions. For example, a central bank must decide how to specify the target: one value or a range of acceptable values. The bank must also decide over what period of time it should measure inflation. This could mean comparing the target to an average of the past three months or perhaps an average over the past year. Yet another decision must be made as to which measure of inflation will be used. Fundamentally, measuring inflation means measuring the growth of a price level, and the variety of choices stem from the variety of different price indices used to measure the nation's general price level.

In the United States, two widely followed key inflation measures are the consumer price index (CPI) and the personal consumption expenditures (PCE) price index. Each index represents a general measure of prices paid by consumers, but they differ in several respects. Some examples of these differences include the scope of goods considered (the PCE is more comprehensive) and how frequently the weights within each index are updated (the PCE weights are updated more frequently). The importance of the PCE is also highlighted by the fact that this index is forecast in the "Summary of Economic Projections" produced by FOMC members four times per year.

Another difference between these two price indices involves the process of data revisions that each index undergoes. Here, the difference between the two indices is quite stark: The CPI is typically subject to revision only because of revised seasonal factors or reporting errors, whereas the PCE is subject to continual, and sometimes large, revisions.1 These data revisions create a potential problem in using the PCE for inflation targeting purposes: The observed relationship between inflation (for any previous point in time) and the stated target could change over time solely because of revisions to the data. Moreover, by the time more accurate data emerge, monetary policy actions may have already been taken based on the initially observed relationship.

This potential problem is the main focus of this Research Rap Special Report. We examine the potential severity of this problem by considering how revisions to past PCE-based inflation data have affected the relationship between inflation and a hypothetical target. We find that initially released data tend to be revised upward and that these revisions can alter the data in several ways that are important with respect to inflation targeting. In particular, revisions can alter the size of deviations from target, even to the extent of changing whether inflation is above or below target, and revisions can alter the record of success seen in hitting the target.

  1. The CPI data are in final form when first released. However, revisions can be made in response to a reporting error, which is rare, or due to the updating of seasonal factors. The revisions due to seasonal factors are generally small in magnitude and are made annually in the computation of seasonally adjusted consumer price indices. In contrast, revisions to the PCE are more substantial, since they incorporate new data collected gradually over time.