Inflation
Basic info:
“Inflation is a persistent rise in the average level of prices over time.” (Bank of Canada)
To measure inflation, economists use another metric: CPI (Consumer Price Index). CPI is the cost of a basket of goods that is essential to households. What’s included in this basket varies across time (see below for more info). Just to provide an extreme example: at a certain point in time, a horse or sword might have been in this basket, but nowadays, it’s cars, computers, etc.
Who measures and publishes CPI in the U.S.? U.S. Bureau of Labor Statistics (“BLS”). Click here to see the latest update on the BLS website.
How is the CPI market basket determined? Here is the answer from the BLS website (under FAQ):
”The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought. There is a time lag between the expenditure survey and its use in the CPI. For example, CPI data in 2020 and 2021 was based on data collected from the Consumer Expenditure Surveys for 2017 and 2018. In each of those years, about 24,000 consumers from around the country provided information each quarter on their spending habits in the interview survey. To collect information on frequently purchased items, such as food and personal care products, another 12,000 consumers in each of these years kept diaries listing everything they bought during a 2-week period. Over the 2 year period, then, expenditure information came from approximately 24,000 weekly diaries and 48,000 quarterly interviews used to determine the importance, or weight, of the item categories in the CPI index structure.”
How frequently is CPI published?
Monthly.
The table below was recreated from the information on the BLS website. As you can see, the CPI increased significantly in June 2022 (year-over-year). The last time we had such a large jump was 40 years ago. The US went through a high inflationary period in the 1970s, nicknamed “the great inflation”. You can read more on this on the Federal Reserve History website.
Source: U.S. Bureau of Labor Statistics. Click here for full article.
To recap, inflation, which means the increase of the price of goods and services, is measured by changes in CPI on an annual basis. So, when we hear that inflation is at 9.1% in June of 2022, it means that a basket of goods that is needed for households to stay alive and functions is now costing them 9.1% more (in terms of dollar) compared with the same time last year.
What is target inflation?
2%
You might ask what is the basis for 2%, and why not 3% or 4%? It’s mostly the empirical evidence that suggests with the current market structure, and all other forces that impact the market (locally and globally, including credit), the 2% inflation works best. Therefore, maybe sometime in the future a new target would be set based on new evidence.
What are core and headline inflation?
Headline inflation takes into account the entire CPI basket, including food and energy
Core inflation excludes food and energy as those tend to be more volatile. Also, food and energy make up approximately up to 15% of total CPI in the developed economies.
If you’re not into economy or investment, you might have never made a distinction between core and headline inflation. But you will hear this distinction a lot in investment community. Core inflation matters more because it’s stickier. It takes longer time to go up and at the same time it takes longer to come down. As you can see in the image above, ‘All items less food and energy’ moved by 5.5% at the same time that food and energy increased by 10.4% and 41.6%, respectively. You can check the next month’s publication. You will probably see that both food and energy are not as high, but then the core is starting to pick up.
What is the takeaway?
Firstly, as explained above, core inflation is stickier. So, when you see optimistic opinions that the inflation is going to come down in three or four months, you will take it with a grain of salt, especially if it comes from a politician.
Secondly, you can expect that Federal Reserve that sets the policy interest rate to react to this. Federal Reserve has dual mandate: keep inflation and unemployment low (plus ensuring financial stability). But what if inflation is at odds with employment and Fed has to pick one? It appears handling inflation has priority over unemployment. For more information, you can read the history of Federal Reserve (we placed a link above), or google ‘great inflation’. Basically, the way US came out of great inflation was to fight inflation first (at the expense of high unemployment and some social unrest), and once inflation was addressed, the economy flourished for many years after. It appears that the current Fed subscribes to this narrative and will handle the situation with tackling inflation having a priority.