Some economists and market participants view inflation as one of the most important economic indicators. Market participants spend a lot of time worrying about a lot of things, but inflation is pretty close to the top of the list most of the time. Not so much for a sustained period of years before covid, when some suggested it was dead, but very so much since, and particularly now.
Hard to pin down what it is. Not that the definition doesn’t seem straightforward: “A sustained increase in the general price level of goods and services in an economy resulting in a decline in the purchasing power of money.” But the axioms on which it is based are all on the squishy side when you start defining them to measure them, to say nothing of the difficulties of the measuring. General, price level, sustained, Goods and services, purchasing power, and money. They are hardly axiomatic. Nevertheless, no matter how imperfect, it’s better to have some indication of where it is and where we think it is headed. That requires choosing a metric, of which there are several. CPI is the one most commonly referenced and used.
See more: The Optics of Inflation
What it affects. Lots of things, of course. Kind of like air. Most importantly it is people and how they live their lives. Affordability, choices and tradeoffs, lifestyle. Happiness and sentiment. It affects companies and their strategies, revenues, costs and employment. And interest rates and the setting of those by the markets and central banks.
The experience and the expectation. CPI measures the past. What we have experienced. Sometimes the reported statistics comport with what we know we actually paid. We may or may not adjust our day-to-day decisions based on this. More like potentially temporary adjustments. Economists think this is less important than what we think prices are going to do in the future. Because that influences how we adjust our planning. Planning adjustments, once made, are harder to reverse, and they can feed upon themselves and cause deeper, longer-term problems. That’s why the Fed watches inflation expectations perhaps more closely than CPI.
How to control it. Let’s just say that 2% is a good place for inflation to be, and we’d like it to be fairly stable around that number. It is a wild and untamed thing; how do you get it to behave and settle into that range? Although Milton Friedman said it’s a monetary phenomenon, there are other factors. Monetary Policy may affect the general part of prices, but the general is made up of the specific. CPI is divided into Core and Non-core with Core being 79%. That leaves (Non-core) food at 13.5% and energy at 7.4%. Core goods makes up 18.8% and core services make up 60.2%. Shelter (which lives in Services) is the biggest single component of the lot at 35.3%. After that its medical, transportation and education and communication at ~6-7% apiece. Your personal basket may vary.
Think there is any energy in any of the other categories? Of course, just hard to say how much. What proportion of the realized prices of these categories get determined by idiosyncratic forces like supply chains or consumer preferences or supply and demand? How much gets determined by monolithic ones like interest rates? How about fiscal policy and government spending and regulation? Maybe free and transparent markets? The markets act as though they expect the Fed to take the lead and that it has a meaningful amount of influence. It is, after all, half of its so-called remit, along with employment. Unfortunately, the transmission mechanism is obscure and operates with lags. But again, we do the best we can.
Where are we now? This past Friday brought us a few interesting data points that may influence our perception of where inflation is now and where it is heading. Bottom line is that it is clearer at the margin that it is not going down and there is less reason to believe that it is going to go down in the near future. Perhaps there is a growing realization that maybe the risk is tilted to the upside. That’s reading the experience part. The expectations part is not going down either. Short term expectations went up a good bit, long-term ticked up a tiny bit. Does something need to be done about it like by the Fed raising rates one or two times? The markets said yes on Friday.
Authored by Tom Martin
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Originally posted on ETF Trends
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