Three Ways to Look at Inflation

“Inflation” is a buzzword these days. No matter where you turn, inflation news is hard to miss.

Even if you never pay attention to the news or go online, if you buy something, you will notice the higher prices. Whether at the pump, in the supermarket or elsewhere, there is nowhere to hide if you are a consumer. The only question is how much more you pay.

Obviously, in times of inflation, the prices of goods and services rise. To catch up, you will need your income to increase as well. If you buy the exact same goods year after year, you can compare what you spent this year to what you spent last year, and the percentage change is the inflation rate of your basket of goods. But if you want to quantify how much prices have risen across the economy, that’s a much more difficult task because there are so many different goods and services available and consumption patterns are changing.

For a consumer, what matters immediately is what he is paying now. It doesn’t matter whether the official inflation rate is, say, 3%, 5% or 8%. If John pays 20% more for his beef today than he did last year, then 20% is what matters, even if the inflation rate is 5%.

The need to quantify inflation

But governments, which set monetary and fiscal policies, must quantify inflation. And it is not a simple task. Since a government cannot measure the spending trends of every citizen with exact precision, it must provide an approximation in the form of indices that represent what a typical consumer can buy.

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Since these indices influence government policy, which in turn affects the economy and financial markets, it is incumbent on investors to have at least a basic understanding of the difference between the most important indices. For example, in the United States, inflation and unemployment are the two factors that most influence monetary policy, like interest rates, which have a major impact on the stock market.

Today we will briefly highlight three of these great US indices.

Basket of goods and services of urban consumers

The most commonly cited measure of inflation is the Consumer Price Index (CPI), maintained by the US Bureau of Labor Statistics (BLS), a unit of the Department of Labor. This index is meant to be a representation of urban consumer spending on a weighted basket of goods and services. It assumes that a typical city dweller will consume a certain group of goods and services and how the cost of that consumption changes over time.

The CPI makes a very important assumption that consumers will substitute one good for another (eg chicken for pork) if the original good becomes too expensive to achieve a constant level of satisfaction. This underestimates the inflation felt by consumers in real life, as the calculation constantly replaces goods and services in the basket with cheaper substitutes. The government also makes certain assumptions that do not take into account the real costs of the calculation. Due to the shortcomings of the CPI, policy makers generally do not base their decisions on this index.

Why use an inaccurate index? Politicians have an incentive to keep the measure of inflation low. It sounds good on political campaigns and reduces benefit increases related to the cost of living.

Inflation from the perspective of producers

The Producer Price Index (PPI) is another BLS index. It measures cost changes from the perspective of domestic producers. The PPI can give an indication of the direction inflation is heading. Producers may be able to absorb higher costs for a while, but sooner or later cost inflation will trickle down to buyers in the form of higher prices. Thus, the PPI is considered a leading economic indicator. A jump in the PPI points to inflation at the retail level.

The index consists of three sub-indices: raw products, intermediate products and finished products, offering an overview of products at different stages of production. Generally, an increase in the cost of raw goods (i.e. raw material inflation like what is happening now) means that the costs of intermediate goods will increase, and then finished goods.

What the Fed cares most about

The third index, the Personal Consumption Expenditure Price Index (PCEPI), is maintained by the United States Bureau of Economic Analysis, a unit of the Department of Commerce. This index is particularly important because it is the Fed’s inflation indicator of choice. When the Fed talks about a long-term inflation target, it is referring to changes to the PCEPI.

The index measures inflation based on information provided by households, businesses and governments, as well as gross domestic product. Unlike the CPI, which only surveys changes at the consumer level, the PCEPI also surveys businesses directly and thus collects more comprehensive information. PCEPI also takes into account changes in consumer spending patterns in the short term.

From an investment point of view, the PCEPI is very important because it directly influences the monetary decision of the Fed. As we have seen, extremely loose monetary policy is a huge tailwind for the stock market. In contrast, Fed tightening is a headwind. So while the CPI is the most widely reported measure of inflation in the media, it is the PCEPI that has the most impact on central bank action.

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