What Investors Must Know About the Fed and Inflation

Prices are edging higher. There is great interest in how the Fed might react. To understand the implications, we need to start with how inflation is measured and then turn to how the Fed thinks about it.

 

The FRED blog puts the main indicators together in one chart.

Key Questions

Why use a “core” calculation? Core values are less volatile and provide a better reflection of the underlying trend. This makes it more valuable for policymaking. It does not mean that food and energy are unimportant. Doug Short’s chart illustrates this point. Read the entire post for a longer time series.

What are the seasonal adjustments? Price changes follow distinct seasonal patterns. These adjustments make sense, but for current purposes I am citing year-over-year data.

Why is this important to the Fed? The Fed’s dual mandate includes both price stability and employment. The definition of price stability is a topic of current debate. The current Fed policy is that an annual increase of 2% in the core PCE index constitutes stability. The Fed wants to control inflationary expectations more than the exact price level. A modest amount of inflation is thought to facilitate economic growth, if it can be expected. The Fed views this target not as an alarm or upper bound, but the middle of a range.

Which measure is best for policy purposes? The FRED Blog analyzes the situation as follows:

What price index should monetary policymakers use to track the economy? For starters, it should have three characteristics: 1) encompass a substantial part of the economy; 2) be available without delay; 3) contain little noise from short-lived price fluctuations. Looking at the four prime candidates, there is no clear front-runner. From the top down: the CPI covers only consumption and includes highly volatile food and energy prices, but it is available quickly. The CPI less food and energy looks more stable and informative, but misses part of consumption. Personal consumption expenditures (drawn from the national income and product statistics) is available only at a quarterly frequency and after a delay of several months, a drawback that pertains also to the GDP deflator. The GDP deflator, though, covers all the economy.

Their interactive chart provides a helpful comparison.

Conclusion

The world has an abundance of inflation cynics. It is natural to think about our personal market basket, not the basis for each calculation. The rising parts of our budget stand out. The savings and quality improvements, not so much.

My purpose is certainly not to convince readers about a “correct” value for inflation. Believe what you will. As an investor, you should put that belief aside. It is more rewarding to understand the viewpoint of policymakers. You can still call them idiots, but at least you will know what to expect!

References:

Difference between CPI and PCE: https://www.bea.gov/faq/index.cfm?faq_id=555

PPI Facts: https://www.bls.gov/ppi/ppifaq.htm#1

GDP Implicit Price Deflator https://fred.stlouisfed.org/series/GDPDEF

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