An entire generation has never experienced the relentless destruction of purchasing power wrought by systemic inflation. After all, it has been more than 30 years since the scourge of double-digit price hikes was routine. Now, after a long period of quiescence, fears of resurgent inflation are roiling markets and commanding the attention of central bankers.
Seems like a good time to consider a few pertinent questions: what is inflation, how do we measure it, and is it really a boogeyman lurking under the bed?
Christopher A. HopkinsInflation is defined as the rate at which the general level of prices in the economy rises over time. Alternatively, one can think of it as the rate of decline in the buying power of the dollar. In a normal, growing economy, some modest inflation is typical and even beneficial. Excessive price appreciation, on the other hand, is destructive and ultimately destabilizing if allowed to get out of control. As with porridge, so also with inflation: not too hot, not too cold, but just right.
In order for policymakers to control inflation, they must first measure it. Several metrics exist that variously lend themselves to particular uses. The most familiar and widely reported number is called the Consumer Price Index or CPI, a broad indicator produced by the U.S. Bureau of Labor Statistics that measures price changes affecting most consumers. This index is computed by tracking monthly prices of a "market basket" containing more than 200 categories of items typically purchased by average Americans. CPI provides a general estimate of the average level of consumer inflation in the economy, and is used in indexing everything from Social Security payments to 401(k) contributions to tax rates.
BLS reported January's CPI rose a moderate 2.1 percent for the previous 12 months, but exceeded expectations at 0.5 percent from the previous month. This hotter-than-expected result sent a chill through the equity markets as investors pondered the potential impact on stock prices.
While headline CPI is the most familiar, there are other measures of inflation. Two categories of spending, food and energy, are notably volatile on a monthly basis and are excised from the index to render the "core" CPI, which is generally smoother and less noisy. Core CPI growth was 1.8 percent for the year but rose 0.3 percent in January.
The Federal Reserve prefers a different measure, known as the Personal Consumption Expenditure or PCE index, from the Bureau of Economic Analysis. While CPI tracks a basket of things consumers buy, PCE follows a basket of goods and services merchants sell. That may seem like a subtle difference, but PCE adds items that are not out-of-pocket consumer expenditures such as medical care provided by employer-paid insurance or Medicare not included in CPI. Economists believe CPI slightly overstates true inflation relative to PCE. Similarly, there is a core version that excludes food and energy. It is the core PCE that is Fed's primary target.
Finally, macro economists employ a broad inflation measure called an "implicit deflator" that does not track a specific basket but implies a broad inflation rate from the price change in GDP over time. By comparing total output in today's dollars with the same volume of output measured in dollars of a base year (currently 2009), a ratio is calculated that represents average inflation in the entire economy. Thus the term "real GDP" means nominal (today's dollar) GDP divided by the GDP deflator. This allows us to compare real (ex-inflation) economic activity across time periods by filtering out the distortion of inflation.
Next week: why inflation matters and tools to manage it.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. Investment Advisors in Chattanooga.