One Thing to Know About Inflation

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One Thing to Know About Inflation

In October 2021, price inflation reached 6.2%, followed by November reporting a 6.8% increase.  Both represent high points last seen in the early 1980s. As the economy reopens, consumers released their pent-up demand after a year at home on an unprepared supply and production chain, using money supplied by Congress and mostly funded by the Federal Reserve. The resulting inflation has received a lot of attention from investors, consumers, and policymakers alike trying to determine its duration.  Even the Federal Reserve has dropped its initial belief that inflation will be short lived and settle at lower levels soon.

Inflation is hard to calculate.  

Lost in the concern over inflation pressures is whether we are looking at the correct data in the first place.  Calculating price indices is hard work.  Price inspectors must avoid sampling error, picking representative items. They must not assign product quality improvements where none exist. They must account for cases where today’s six t-shirts cost what yesterday’s eight did. And they must consider cost differentials across different geographic regions.

We calculate inflation in many ways, but two methods are used and referenced more heavily than others.  The Bureau of Economic Analysis calculates the personal consumption expenditures index (PCE), while the Bureau of Labor Statistics calculates the consumer price index (CPI).  For reasons due to formula, scope, and weight, they often disagree.

 

PCECPI
FormulaConsiders substitution decisionsUses an average price for representative items
ScopeMeasures expenditures by all householdsMeasures expenditures by urban households
WeightDerived from business surveysDerived from household surveys

 

Formula

Different formulas underpin the PCE and CPI indices.  PCE uses a procedure that reflects consumer substitution decisions among detailed items as prices change.  If a rise in beef prices led to consumers choosing chicken instead, the PCE formula wants to consider that decision.  In contrast, CPI doesn’t account for those substitutions and relies on an average-price approach for the representative items selected in advance.

Scope

PCE measures expenditures by all households, whereas CPI measures the expenditure change only for urban households.  As a result of using a broader base, some expenses in the PCE index are outside the scope of the CPI.  For example, medical expenses for PCE include services paid for on behalf of consumers by employers, employer health plans, and medical care paid for by the government.  CPI only considers out-of-pocket costs paid by consumers.

Weight

The PCE and CPI indices are based on different data sources and apply different weights to the respective categories.  PCE weights derive from business surveys conducted by the Census Bureau each month. In contrast, household surveys conducted by the Census Bureau determine CPI weights.

For example, shelter accounts for the most significant weight difference between the indices. The share of personal spending devoted to housing is smaller in the PCE, 16%, than in the CPI, 33%.  The fact that shelter spending in the business surveys used for PCE is less than those from household surveys used for CPI explains the gap.

Until 2000, CPI was the prevalent inflation measure noted in contracts, invoked in wage agreements, applied to Social Security benefits, followed by casual observers, and used by the Federal Reserve to set monetary policy.  After 2000, the Federal Reserve switched to the PCE, preferring the historical consistency so valuable for research.  Unlike CPI, which is written into contracts and cannot be changed once published, PCE data allows revisions to reflect updated information and refined measurement techniques.

Beyond the specifics of inflation calculations, the important conclusion we wish to draw are inflationary trends, for which we can review more than just PCE and CPI.  Both have versions that exclude food and energy costs on the theory that those two categories are more volatile than the others.  Their removal allows for a more stable average that better reflects inflationary trends.  Various other inflation iterations, both core and otherwise, strip out the most extreme monthly price changes.

No matter how we calculate inflation, there is no doubt it is here and must be dealt with. Businesses are doing everything in their power to address supply chain issues. But policymakers are behind the curve.

Disclosure: https://mitchcap.com/disclosure/

2021-12-29T10:38:12-06:00 June 18th, 2021|Economy, Inflation, Monetary Policy|0 Comments

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