Watching for Inflation
Fed officials eventually need to decide when to tighten monetary policy and raise the benchmark interest rate, which has been near zero since 2008. Most Fed officials believe the first rate increase will occur in 2015, but the exact timing hinges on how quickly inflation rises and when the employment situation improves.1
As a result, economists, businesses, and investors could be watching key inflation measures more closely than ever. The following government indexes cover various types of products and services and are calculated differently, which could make them useful for detecting inflation in the nooks and crannies of the U.S. economy.
Fed Switch: CPI for PCE
The Federal Open Market Committee (FOMC) aims to keep inflation near a 2% target, which is consistent with the Federal Reserve’s mandate to promote stable prices and maximum employment. The price index for personal consumption expenditures (PCE) is the FOMC’s preferred measure of inflation, primarily because it covers a broad range of prices and picks up shifts in consumer behavior.2 The Fed also focuses on core measures, which strip out volatile food and energy categories that are less likely to respond to monetary policy.
The typical American might be more familiar with the consumer price index (CPI), which was the Fed’s favorite inflation gauge as recently as 2012.3 Still widely cited, the CPI is currently used to determine cost-of-living adjustments for Social Security. The CPI only measures the prices that consumers actually pay for a fixed basket of goods, with weightings that do not change on a regular basis.
The PCE index tracks the prices of everything that is consumed, regardless of who pays. For example, the CPI includes a patient’s out-of-pocket costs for a doctor’s visit, while the PCE index considers the total charge billed to insurance companies, the government, and the patient. The PCE methodology uses current and past expenditures to adjust category weights; it is a chained measure that reflects consumers’ tendency to substitute less expensive goods for more expensive items.4
Scope Expands for PPI
The Labor Department’s producer price index (PPI) measures wholesale prices paid by businesses. It actually consists of a set of indexes that track prices throughout all stages of the production process.
In January 2014, the U.S. Department of Labor changed the PPI methodology, doubling its scope to 75% of U.S. economic activity. Although the index previously tracked only the wholesale prices of goods bought by consumers and businesses, now it also captures services and construction, in addition to goods and services exported or bought by the government. The updated PPI could provide a more comprehensive view of price changes in an increasingly service-oriented U.S. economy.5
The PPI is often considered an early warning of inflation pressures, but it does not always anticipate changes in retail prices. Businesses could raise retail prices quickly as economic conditions and consumer confidence improve, because rising costs that can’t be passed on to customers tend to have a negative effect on a company’s bottom line and future prospects.
One fear is that the Fed won’t move fast enough to counter inflation as the economy heats up. Investors might want to consider the possibility of higher inflation in the future, because even modest price increases compounded over time can erode the purchasing power of portfolio assets.