Policymakers, businesses, and investors all keep a close eye on inflation, which is the
rise in cost of goods and services.
A little bit of inflation is a sign of economic growth, while too much inflation can hurt
the economy.
But with millions of goods and services bought and sold every day, how do we actually know
how much things cost across the whole economy?
That’s where the inflation indexes come in.
Inflation indexes gather price data from various sources across the economy and compile them
into one number to give a snapshot view of how much things cost.
Seeing how much and how quickly prices are rising or falling can tell you a lot about
economic growth that drives financial markets and your investments.
There are three main inflation indexes that we’ll focus on: the CPI, or Consumer Price
Index, the PCE, or Personal Consumption Expenditures Price Index, and the PPI, or Producer Price
Index.
Each inflation index is compiled and calculated differently and has different purposes.
Let’s start with the Consumer Price Index, or CPI.
The CPI is released by the U.S. Bureau of Labor Statistics, or BLS, every month.
Simply put, it’s a measure of Americans’ purchasing power and is used by policymakers
to understand the cost of items over time.
To calculate the CPI, the BLS creates what’s called a “basket” or collection of goods
and services representing things the average American buys.
The main basket is divided into sub-baskets like housing, food, and clothing, which are
weighted based on importance and then averaged to find the overall CPI
For example, the CPI in January 2022 rose .6%, and up 7.5% year over year.
This dramatic increase was fueled by a combination of supply chain issues and economic stimulus
related to the pandemic recovery.
However, of the eight baskets the CPI tracks, the two that rose the most from January 2021
through January 2022 were food, which rose 7%, and energy, which rose 27%.
The CPI is used in a few ways.
First, it’s used as a cost of living gauge to determine government benefits like Social
Security, food stamps, and pensions.
It’s also used to adjust Treasury Inflation-Protected Securities, or TIPS, a type of government
bond where the principal changes with inflation.
Another common inflation index is the PCE, or Personal Consumption Expenditures Price
Index.
The PCE is released monthly by the Bureau of Economic Analysis.
It’s similar to the CPI in that it measures the price of goods and services, but it weights
the baskets that comprise it differently.
Where the CPI checks in on 80,000 products, the PCE pulls its data from the gross domestic
product report, representing 100% of the U.S. economy, including non-profits and corporations.
The CPI is susceptible to large swings from one basket, whereas the PCE’s formula smooths
out the data.
The PCE also accounts for consumer behavior changes in response to rising prices, making
it more accurate than the CPI.
Because of this, the Fed uses the PCE as its primary inflation metric when determining
monetary policy.
Traditionally, the Fed targets an inflation rate of 2%, which is in line with healthy
economic growth and price stability.
When looking at the PCE from 2020 through 2021, you’ll see there was a sizable drop
in spending due to the pandemic. 2021’s results show Americans spent more year over
year in a lot of sub-baskets but more so on energy.
For example, a combination of reopening economies and OPEC choosing to limit supply caused gas
prices to soar.
Finally, there’s the Producer Price Index, or PPI.
The PPI is released monthly by the U.S. BLS.
So, where the PCE and CPI are measuring the experience of consumers, the PPI looks at
what’s going on with the producers of goods and services.
It’s created by 25,000 establishments sending approximately 100,000 price quotations every
month.
The PPI is calculated by dividing the current price of items received from wholesale sellers
of products in a given basket by the prices of those same products in a base year, which
is 1982, and then that number is multiplied by 100.
The information is useful in a lot of ways.
Producers can compare prices of a given product or industry to inform their pricing strategy.
It can also be used to foreshadow price changes for consumers.
The assumption being if producers are paying more for wholesale, there’s a higher chance
consumers will pay more for retail items.
The government uses the PPI to inform its monetary and fiscal policies aimed at limiting
inflation.
From January 2021 through January 2022, the PPI saw a wholesale price increase of 9.7%
across the board.
It shows that businesses paid a lot more for their goods than they did pre-pandemic.
If businesses are paying more, the extra expenses could be passed along to consumers, which
is what we’re seeing in both the PCE and the CPI.
I want to mention there are different variations of each of these indexes that alter one variable
or another.
So, if you’re interested in learning more or want to see how small tweaks alter the
results, there’s plenty more data to comb through.
For example, each sub-basket that comprises the CPI has its own index.
It's also important to point out how volatile the baskets of food and energy have historically
been.
Both baskets can swing violently in either direction, making long-term trends difficult
to discern.
Some economists look at core inflation, which strips out food and energy, because core inflation
tends to be more stable.
So, what does inflation mean for your portfolio?
In the markets, high inflation is typically bad for fixed income investments like bonds
or dividend stocks.
That’s because the fixed payments are now worth less due to a decrease in buying power.
When inflation is low, you don’t lose buying power, so investors are happy with their fixed
payments.
On the flip side, high inflation is usually good for value investing.
Value stocks are companies trading at a lower price than what the company’s performance,
the actual bottom line, might suggest.
Value stocks can have high dividend yields, low price-to-book ratios, and low price-to-earnings
ratios.
Value stocks may perform better in inflationary environments because the value of their earnings
is more current than their growth counterparts.
Further-dated earnings tend to erode faster, so growth stocks may underperform.
The CPI, PCE, and PPI together can paint a picture of inflation in the United States.
Investors can use the information to investigate broader trends in different sectors.
They’re another useful tool in your investor toolbelt.