The Fed’s “Evolving Logic” Will Beat Inflation

Big day today!

The Bureau of Labor Statistics released its  CPI inflation report for the month of August. Being that I have to get these letters to my editor in advance of publication, I don’t know what got printed or how the market reacted.

But with year-over-year inflation sitting near 40-year highs (a brief downtick coming in last month) and the Fed on a rate-raising rampage to control it… I’m sure it was exciting. 

Inflation numbers have always been what you might consider “rockstar” economic reports. 

There are other reports that carry “rockstar” status… Numbers like unemployment / non-farm payrolls. Despite the fact it’s a lagging indicator, GDP (the advance estimate, at least) generally commands the market’s attention. 

To some degree even reports like retail sales, producer prices and a couple consumer sentiment numbers generate some buzz. 

They all have this status because they’re easy to talk about by the folks who talk about these things in the media — everybody understands inflation.  

Nobody but the geekiest analysts fawn over “export prices” or “capacity utilization.” 

The Problem with Economic Reports

In the world of economic reporting, the simpler to understand, the better. Saying that prices rose 9.1% or 8.5% over the previous 12 months is pretty straightforward. 

The problem is, the evolving logic that goes into calculating those numbers is anything but simple. 

For instance, the concept of the CPI dates all the way back to 1917 — but it’s far from the same number calculated back then. 

Originally it followed prices in a fixed basket of goods — which would make sense if you wanted to track the price of items in a basket of goods. But as time passed and inflation kept rising, the calculation was changed to reflect the ability to maintain a (much more subjective) standard of living

“According to the BLS, the changes removed biases that caused the CPI to overstate the inflation rate. The new methodology takes into account changes in the quality of goods and substitution. Substitution, the change in purchases by consumers in response to price changes, changes the relative weighting of the goods in the basket. The overall result tends to be a lower CPI.”

So if you’re looking at the long term trend of inflation, what are you really looking at? The cost of a basket of goods? Or the cost of some subjective standard of living?

On top of this, they calculate a “core” version of the index as well where they leave out food and energy prices. They do this based on the idea that the volatility of these two commodities skews the monthly readings. 

So while the basic concept of the report is easy to understand, once you start getting into the weeds a little, the picture gets a lot foggier.

The Fed’s Personal Inflation Number

In 2012 the Bureau of Economic Analysis (BEA) began calculating an alternative to the BLS’ CPI — the Personal Consumption Expenditure Price Index or PCE. 

These calculations differ in a number of ways. For instance, they weight the components in their baskets differently. They survey different targets (CPI surveys households for what they’re buying while PCE surveys business for what they’re selling).  CPI counts only out of pocket expenditures while PCE factors in payments from third parties — like your insurance. And finally there’s the “formula substitution” effect — PCE allows short term substitutions of cheaper items while the CPI revises its basket every couple years.

You can guess the result of this evolving logic

The latest CPI numbers (not today’s) came in at 8.5% overall and 5.9% for the core reading. 



PCE, on the other hand, came in at 6.3% with its core measure at only 4.6%.



Chairman Powell has acknowledged that Headline CPI is the number most people are concerned about. 

But given how far above the Fed’s inflation target both these numbers are, don’t be surprised if they start re-emphasizing their preferred measure because… evolving logic.

There are some economic reports with less than rockstar status that are worth watching. I want to share one of them with you in your next letter.

Make the trend your friend,

Bob Byrne
Editor, Streetlight Daily