Understanding inflation

Inflation numbers bled across the headlines this week. Wonks measure inflation in different ways. Some capture the growth in prices we will face as consumers, while others try to cut away noise to get at core inflation, and so are used to set interest rate policy. Let’s walk through the options so you can better understand what might be coming.

Consumer Price Index (CPI)

• A rapidly opening economy, and the supply chain chaos that ensued, mixed with the increased money supply in the market, resulting in the CPI hitting 6.24% in October — the highest in three decades.
• The surge in CPI over October was unexpected. September numbers had reflected an insignificant change and remained below the highs seen in the 2000s.

The CPI focuses on prices in urban areas and is sourced from the Consumer Expenditure Survey (two surveys of consumers about what they purchase). It measures the price of a fixed, typical basket of goods. Economists take the price changes on individual goods and then combine them together by placing different weights on different products. The weights reflect how much we collectively spend on a given item relative to other items in the basket and change very slowly as new items are added to the typical basket of goods and others become obsolete. That’s the fixed part. But by fixing the weights, the CPI does not account for the ability of the consumer to swap out products to avoid price spikes.

Personal Consumption Expenditure (PCE) Price Index

• More mild that the consumer price index for reflecting our substitution away from suddenly expensive goods, the September PCE was a full percentage point below the CPI at 4.38%.

The Personal Consumption Expenditure (PCE) Price Index , favored by the Fed, is like the CPI, but covers more areas of the economy and accounts for substitutability between products. Unlike the CPI, the PCE includes prices from rural areas and includes expenditures purchased on behalf of consumer — things like health care provided by government or employers. It is sourced from the National Income and Product Accounts (NIPA), a dataset of what producers sell at what prices administered by the Bureau of Labor Statistics. The weights placed on different items are dynamic as the amount that consumers purchase of that item changes. This means the PCE does a better job reflecting a consumers ability to avoid an isolated price spikes and buy a close substitute instead.

Trimmed Mean Personal Consumption Expenditure (TM-PCE) Price Index

• After having offered many wonks the comfort that severe inflation had not yet reach the core, the jump of 0.3 percentage points in September to 2.33% was a surprise.
• Still below recent highs, experts (me) anxiously wait on October numbers expected later this month. Continued aggressive growth here will likely lead the Federal Reserve to pull back their support of housing markets faster than originally anticipate and could lead to significant volatility in interest rates.

The Trimmed Mean PCE, produced by the Dallas Fed, is like the PCE discussed above but also removes the products with the most extreme price volatility. This measure best captures core inflation when experiencing pandemic induced supply chain havoc and pent up demand. (This measure is my favorite.)

Employment Cost Index

• Wages growth surged more than a percentage point over the second quarter to 4.6%, a significantly faster pace than pre-pandemic.
• Wages growth finally surpassed 3% in mid-2018 after growing very slowly out of the Great Recession.
• The next release of ECI numbers are much anticipated. Covering the third quarter, they are expected to reflect the efforts of employers to entice workers during the Great Resignation.

The employment cost index tracks the growth in wages and salaries of private industry workers and so is critical to capturing the economic health of the U.S. labor force. However higher wages also translate to higher costs of production that sometimes gets passed on to consumers in the form of higher prices.

Not always though. Higher wages provide higher stakes for maintaining employment and at low wages can increase productivity by covering more of life’s more extreme stressors like food, shelter and the ability to take a break. Or in an economist’s vernacular: efficiency wages can increase productivity and offsets the higher cost per unit of labor. The ECI is sourced from the National Compensation Survey by the BLS.

Breakeven Inflation Rates — Using the wisdom of the market

• Financial markets updated their expectations on the average inflation we should expect over the next several year. Steady for a few months near 2.5%, the 5-year breakeven inflation rate jumped to 2.75% in October, the market’s vote on average inflation over that time period.

Because the U.S. is generally considered such a good bet on the global stage, U.S. treasury bills are considered very low risk. If you are lending money and not getting a return for real risk, then the compensation you’re expecting needs to at least exceed inflation for it to be a good idea. So the prices for treasury bonds at different time horizons can be used to give us the market’s vote on what inflation will be on average over that time period.