A Better Mousetrap

By Reber, Jim | Independent Banker, May 2006 | Go to article overview
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A Better Mousetrap

Reber, Jim, Independent Banker

Insight into the Fed's favorite inflation gauge

Those of us who have a vested interest in the level and direction of Fed Funds know the new Federal Reserve Chairman Ben Bernanke is going to have his every word carefully scrutinized, and his every move closely watched, as we try to get a grasp on the nuances of his administrative style.

Will the chairman be an inflation hawk as some Fed watchers suspect? Will he attempt to perform a very public ballet in balancing the economic expansion versus price stability issue at which his predecessor, Alan Greenspan, proved to be so proficient?

At the very heart of this debate is the measurement of inflation-both historic and anticipated. And, as we shall see, the various measurements of price level changes have been experiencing a departure from their historical patterns. It would therefore be instructive to review the more popular inflation indices, and their current levels, to get a grasp on some of the most important data which the Federal Open Market Committee has at its disposal when making monetary policy decisions.

Traditional Yardstick

If someone asks you, "Where is inflation running?" what would be the most likely basis for your answer? I would most likely use the Consumer Price Index (CPI) yearover- year change-the "overall" rate-for several reasons.

One, it is a very easy-to-find index; the monthly announcement is usually prominently displayed in any number of market letters, newspapers or business-related Web sites.

Two, CPI takes into account a basket of goods and services which the Bureau of Labor Statistics tells us represents the American consumer's likely buying activities. The index should therefore be fairly true to the change in costs for the goods and services being measured.

Three, year-over-year annualizing takes out monthly aberrations. And four, it is a very popular measurement for cost-of-living adjustments for numerous privatesector employers, and is the designated index the Social Security Administration uses for changes in its monthly payments to retirees.

Normally, the overall rate and the "core" rate (which excludes the volatile food and energy components) run very closely to one another. The bond market pays close attention to the core rate. Over the last 20 years, the overall and core CPI have averaged an annual increase of 3.1 percent and 3.0 percent, respectively. One could reasonably argue that ignoring food and energy was appropriate from a long-term perspective.

More recently, however, there has been a disconnect in the relationship between the two. For example, in 2005 the overall and core rates rose 3.4 percent and 2.2 percent, respectively (see Table 1). Ignoring the more volatile sectors has become very difficult as we've noticed that it takes a fifty to fill up the family Hummer.

Wholesale Measures

Another commonly referred-to inflation gauge is the Producer Price Index (PPI). Like its cousin CPI, PPI is released monthly by the BLS in both an overall and core form. It does have some differences (e.g., it measures only input prices of goods), which could cause it to not track consumer prices very well.

Globalization, excess capacity and improved productivity all conspired to push the PPI into negative territory on a year-overyear basis between October 2001 and October 2002.

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