February 2023: Explaining Inflation

Inflation has been in the news for much of the last year or so, and current inflation levels aren’t something most current investors have previously experienced. Let’s explore the basics of inflation and provide some outlook based on current conditions. Overall, inflation represents the rate of change in a consumer’s purchasing power. When inflation is positive, it means prices have gone up. In that case, consumers can’t afford to purchase as much as they could previously. For example: imagine that your grocery budget is normally $100 per week. In an inflationary environment, the same basket of groceries might rise to $125 per week. As a result, you will purchase fewer items to stay within your desired budget.

How is inflation measured?

There are several calculations used to measure inflation, each with its own purpose:

Consumer Price Index (CPI)

The most common inflation measurement is the Consumer Price Index, or CPI. CPI is calculated by the Bureau of Labor Statistics (BLS) and it measures the rate of change in consumer prices using a basket of goods approach. The measurement of CPI is weighted based on several different categories of goods and services including housing (which is roughly 1/3 of the calculation), food, energy, health care, transportation, among others. While CPI is calculated monthly, it is most often shown as a year-over-year measurement. Another interesting factor: CPI’s calculation is based only on urban households and ignores rural or non-metropolitan households.

Personal Consumption Expenditures (PCE)

Another measurement for inflation is known as Personal Consumption Expenditures (PCE). PCE is calculated by the Bureau of Economic Analysis (BEA), is also calculated monthly, and most often presented using year-over-year measures. Different from CPI, however, PCE is a broader measure that includes both urban and rural households, as well as nonprofit institutions serving households.

Producer Price Index (PPI)

While CPI and PCE are focused on consumer prices, don’t forget about a third measure of inflation, the Producer Price Index, or PPI. Also calculated by the BLS monthly, PPI measures the average rate of change of prices for domestic producers.

Both CPI and PCE are displayed with “headline” and “core” results. Headline results show the inflationary impact of the entire basket while, in contrast, core inflation strips out the impact of the food and energy baskets, which tend to be quite volatile.

The Federal Open Market Committee (FOMC), which sets the Fed Funds rate and is focused on inflation as one of their key mandates, uses Core PCE as their preferred inflationary measure. For one, they like the fact that PCE is a broader measure vs. CPI. They also prefer looking at core over headline PCE because they feel that any rate changes they make have much less impact on food and energy. Those components are considered more commodity-like and tend to be driven by other external factors, including geopolitics. So, stripping food and energy out makes more sense for their purposes.

And one additional note about the use of year-over-year (YoY) inflation calculations: those figures don’t necessarily represent the most recent data or experience. A YoY calculation as of December may be high because inflation was high in March, April, and May, even though it may have been modest in November or December. Therefore, if you really want to see what inflation looks like more recently, opt for a month-over-month observation.

Is some inflation OK?

Economists will tell you that having some inflation is actually a good thing, as long as it is low, stable, and somewhat predictable. In other words, inflation on its own is not necessarily bad, but rapidly changing or high inflation can be challenging. The Fed targets average annual inflation of 2%.

Can inflation be controlled?

In the U.S., the FOMC has a dual mandate of stable prices and maximum employment. They can’t control either metric, but their policies influence both. Related to inflation, the FOMC will use the Fed Funds rate as a way to impact inflationary trends. For example, raising rates when inflation is thought to be too high, like they did in 2022 and early 2023. The idea is simply that higher rates will lead to reduced spending, and get inflation under control. While central banks outside the U.S. may have different mandates, their use of raising rates to keep inflation in check is common.

What about all the other “-flations”?

While we have been focusing on inflation to this point, there are other “-flations” that investors should also understand:

Disinflation: the slowing of inflation
Though inflation is still higher than desired in 2022 and 2023, the rates have slowed and showed promise of heading in the right direction.
Deflation: the decrease in prices of goods and services.
This can be very troubling from an economic perspective because of its ability to keep consumers from spending money today in the hopes of waiting for better prices in the future. For example: if you are buying a car today that costs $25,000, and if you expect that it will only cost $22,000 in the near future; you might wait to purchase the car at a lower price. If all consumers did this at the same time, this would be an obvious drag on growth.
Stagflation: a period represented by high inflation, high unemployment and a stagnant economy all happening at the same time.
Periods of stagflation have historically occurred during severe periods for the economy, which fortunately have been quite rare (the 1970’s and early 1980’s were the last time the U.S. experienced stagflation).

Summary

While the FOMC has been raising rates in the US repeatedly to get inflation back under control—and although the cost of borrowing money has dramatically increased—we see a light at the end of the tunnel as inflation slows and the rate increases do as well. Nevertheless, as we know from history, the road from higher inflation to more normal levels of inflation is not necessarily going to be a straight one. Hopefully this brief overview on inflation provides some helpful context as you navigate what lies ahead.