Making Sense of Inflation for COLA Raises

Which inflation index should your church use as a benchmark for COLA changes in the coming year?

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You need to figure out a COLA figure for next year’s budget. Different government agencies use different indexes for their COLA. Which one should you use and why?

This article is designed to help you cut through the headlines and make an informed decision based on all the facts.

To supplement this article, consider these additional resources:

[updated: April 2, 2024]

Quantifying inflation

The goal of all inflation indexes is to track the changing cost of goods and services over time. To accomplish this, two federal agencies have developed several different methodologies. The Bureau of Labor Statistics (BLS) produces the Consumer Price Index (CPI), and the Bureau of Economic Analysis (BEA) creates the Personal Consumption Expenditures price index (PCE). Each index comes in a “core” and “headline” flavor.

There are two major challenges that the government faces when it comes to tracking inflation:

Volatility: Prices increase but they also decrease based on market forces. The price of gas, electricity, and airline tickets over the last several years perfectly illustrate this volatility. Just because it goes up doesn’t mean it will never come down.
Behavior: Consumers spend money differently when prices go up. People drive less, buy chicken instead of beef, defer purchases, and cut back on discretionary spending.

Every inflation index appears to answering a very specific question: “How much less is a dollar worth now than it was a year or a month ago?” Unfortunately, because no one can directly measure this difference every index is actually answering a slightly different question: “How much can a dollar buy, on average, in today’s market versus a year or a month ago?” This is why there are different inflation indexes. Each one is answering this “purchasing power” question in a slightly different way.

Two indexes in two flavors

The chart below condenses some of the differences between the two major indexes and their respective flavors.If you want to explore the difference between the CPI and PCE further, we recommend reading this excellent 2014 article by the Federal Reserve Bank of Cleveland.

ChurchSalary has condensed two decades of inflation data into the single chart below. Inflation in the United States peaked in the summer of 2022, decreased drastically over the course of 2023, and has almost returned to normal.

CPI or CPI-U

The Consumer Price Index for Urban Workers—often simply called CPI in the news—measures the buying habits of people who live in urban or metropolitan areas in the United States.

This is the figure you see in every news story. It tracks average percentage change in prices for over 200 items for roughly 90 percent of the population.

Because CPI is unable to model consumer behavior and tends to magnify price volatility, the Federal Reserve does not use CPI to gauge the underlying trend of inflation. Despite its inability to model consumer behavior (and its tendency to overestimate inflation), CPI is directly tied to certain financial transactions and is used by government agencies to adjust income and poverty levels based on inflation.

Core CPI

To minimize volatility, the BLS strips away certain goods and services (e.g., certain energy and food prices) to get a better sense of core inflation. Whenever news stories mention the “core inflation rate,” they are referring either to Core CPI or Core PCE.

Chained CPI or C-CPI-U

The government developed Chained CPI to address the inability of regular CPI to model consumer behavior. This chained-dollar index assumes that some consumers will purchase lower cost options using price data from a previous period.

The flaws of regular CPI have led to a movement within the federal government to use the Chained CPI for many income and poverty measures. For example, the 2017 Tax Cuts and Jobs Acts (TCJA) bill attached federal tax bracket increases to Chained CPI.

PCE

The Personal Consumer Expenditures Price Index is designed by the Bureau of Economic Analysis (BEA) to track both “a wide range of consumer expenses” as well as “changes in consumer behavior.” It measures the out-of-pocket expenses for consumers, even costs borne by employers such as health insurance, by tracking what businesses are actually selling.

Core PCE

To minimize volatility, the BEA strips away certain expenditures to create a measure of core inflation called Core PCE. Because this index is better able to reliably predict long-term, permanent changes in inflation over time, the Federal Reserve uses Core PCE to make policy decisions about inflation that impact the US economy such as raising or lowering interest rates or enacting Quantitative Tightening.

If you really want to dig deep on inflation, you could also research the Dallas Fed trimmed-mean PCE inflation rate.

The difference between CPI and PCE

Both indexes weigh the cost of goods and services like items in a shopping cart. The biggest difference between each cart is how they source prices. As the Federal Reserve Bank of Cleveland notes, “The CPI is based on ... what households are buying; the PCE is based on ... what businesses are selling.”

By basing its calculation on business sales, the PCE is better able to model how consumers are altering their buying habits in the face of higher prices (e.g., less red meat and fewer airline tickets). By comparison, the regular CPI reflects the worst-case scenario for consumers (as if they are making no changes to their behavior).

Turning indexes into a COLA

Each of the five indexes is telling a different story about inflation. It is tempting to listen only to the most exciting or comforting stories, but the truth is probably somewhere in the middle. The chart below summarizes all five indexes alongside ChurchSalary’s data on COLAs from the last two State of Church Compensation Surveys.

ChurchSalary recommends that in times of volatility churches lean on the Core PCE index and in times of relative calm, they lean on the PCE.

How are churches responding?

Every year, ChurchSalary conducts a State of Church Compensation survey to track COLA and budget changes. The two charts below summarize results from the last two budget cycles (2023 actual and 2024 anticipated).

The chart below contains data on median and average changes in 2023. The blue values reflect anticipated changes or predictions from the 2022 survey, while the green values reflect the actual changes based on our 2023 survey.

Finally, the chart below visualizes the distribution of church responses to our 2023 survey about anticipated COLAs for 2024 budgets.

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