US financial markets have been roiled recently by something neither the economy nor investors have had to contend with for the better part of a decade: concerns they may soon have to reckon with rising inflation. The S&P 500 is down more than 7 per cent from its lifetime high hit on January 26 through February 15, after falling as much as 10.2 per cent, and yields on the benchmark US 10-year note have climbed to a four-year high, largely due to inflation worries.
What exactly is inflation, aside from a rise in prices for goods and services, and why is it having such a strong influence on markets? Inflation is measured in a number of ways by various government agencies, and as long as the economy continues to expand it will be a consideration for markets.
Investors will get the latest inflation data on Thursday with the monthly Producer Price Index.
While inflation decreases consumer purchasing power, a certain level of inflation is considered a reflection of a strengthening economy and the impact on consumers can be offset by rising wages.
The US government publishes several inflation measures on a monthly and quarterly basis. The main measures are the Consumer Price Index (CPI) and the personal consumption expenditures (PCE) price indexes. The CPI and PCE are constructed differently and perform differently over time.
The monthly CPI, compiled by the Labour Department’s Bureau of Labour Statistics (BLS), measures the change in prices paid by consumers for goods and services. The BLS data is based on spending patterns of consumers and wage earners, although it excludes rural residents and members of the Armed Forces.
CPI measures the prices that consumers pay for frequently purchased items. The components are weighted to reflect their relative importance, with the weightings derived from household surveys. Some of the components of the CPI basket such as food and energy can be volatile. Stripping out food and energy from the CPI gives us the core CPI, seen as a measure of the underlying inflation trend.
The January reading on consumer prices showed prices rose more than expected, up 0.5 per cent versus the 0.3 per cent expectation. The core reading rose 0.3 per cent against the 0.2 per cent forecast. Both numbers increased from the 0.2 per cent reading for December.
Another reading is the Producer Price Index (PPI), which measures prices from the seller’s point of view.
The Federal Reserve, whose mandate includes price stability along with maximum employment, prefers the personal consumption expenditures (PCE) price indexes constructed by the Commerce Department’s Bureau of Economic Analysis. PCE is considered to be more comprehensive because it includes some components that are excluded from the CPI. According to the BEA, the PCE reflects the price of expenditures made by and on behalf of households. Weights are derived from business surveys.
Housing has a greater weighting in the CPI than in the PCE index. The weighting for medical care is greater in the PCE price index than in the CPI. As with CPI, food and energy components of the PCE are volatile. Stripping them out yields the core PCE, which measures the underlying inflation trend. The core PCE is the Fed’s preferred measure for its 2 per cent inflation target.
The government’s monthly employment report for January, released on February 2, showed wages posted their largest annual gain in more than 8-1/2 years, suggesting the economy was moving closer to full employment and inflation was on the horizon.
If the economy continues to gain momentum, inflation is likely to rise further towards the Federal Reserve’s 2 per cent target. — Reuters
Chuck Mikolajczak & Lucia Mutikani