What is inflation, and what does the Fed do to track prices?

Inflation affects the economy in big and small ways. High inflation reduces consumers’ purchasing power and can eat into investment returns leading to interest rate hikes. Deflation suggests lower demand for goods and services, which can slow economic growth, depress wages, and push up unemployment. The Federal Reserve (Fed) — the country’s central bank and chief financial institution — is responsible for keeping prices stable. That means not too high and not too low. So, what is inflation, and how does the Fed track it?

What is inflation?

Inflation is the rate of price increases for commodities, goods, services, labor, and assets. Deflation is when prices decrease. And disinflation is when prices rise — but not as much as they have previously.

What impacts inflation?

Prices adjust to the changing balance between demand and supply for any particular thing. If there’s more demand or less supply for that thing, the price goes up. If there’s less demand or more supply, the price goes down.

What are headline inflation and core inflation?

Headline inflation measures prices in all categories, while core inflation excludes food and energy prices.

Why exclude food and energy? These prices tend to be more volatile and are often impacted by temporary forces. A singular weather event can destroy crops and push up food prices. Geopolitical conflicts can influence gas prices at the pump. Core inflation is generally seen as a more reliable guide to the underlying inflation rate since it’s not impacted by these short-term events. It’s the Fed’s preferred measure.

What is the Consumer Price Index (CPI)?

CPI data, published monthly and used extensively, is considered a strong proxy for inflation. The US Bureau of Labor Statistics (BLS) gathers data on the movement of prices paid by consumers in 75 urban areas for a basket of more than 200 goods and services including food and beverages, housing, apparel, transportation, medical care, recreation, education, and communication. Approximately 80,000 prices are gathered throughout a given month. This is what’s used to calculate the CPI.

What is the Personal Consumption Expenditures report (PCE)?

Published monthly by the Bureau of Economic Analysis (BEA), the PCE measures consumer spending on goods and services within the US economy. That sounds a lot like the CPI, but there are some differences. For example, the basket of goods and services they measure are somewhat different, as are the formulas they use to make their calculations.

Here’s how the Federal Reserve Bank of Cleveland describes it:

“The details can get quite complicated, but the gist of the matter is that the PCE tries to account for substitution between goods when one good gets more expensive. Thus, if the price of bread goes up, people buy less bread, and the PCE uses a new basket of goods that accounts for people buying less bread. The CPI uses the same basket as before (again, roughly; the details get complicated).”

There are other technical differences as well. But what’s most important for investors to know is that the Personal Consumption Expenditures Price Index, which tracks changes in the PCE data, is preferred by the Fed over the CPI. In particular, the Fed relies on the Core PCE index.

What are inflation expectations, and what role do they play?

Inflation expectations are measures of what consumers, professionals, and even markets anticipate inflation will be in the future. There are two different types of inflation expectations, survey-based (most prominent are consumer surveys but there are also professional surveys) and market-based.

• Survey-based expectations have been predictive of future inflation. They affect the consumption decisions of households, turning expectations into self-fulfilling prophecies. For example, expectations of higher prices in the future typically induce consumers to purchase goods now, increasing aggregate demand and driving up prices. Former St. Louis Fed President James Bullard explained that, in addition, “Firms and households take into account the expected rate of inflation when making economic decisions, such as wage contract negotiations or firms’ pricing decisions.”¹
• Market-based inflation expectations are also important to follow because they’ve been shown to affect the prices of a variety of assets. As Fed Chair Jay Powell has acknowledged, “Inflation expectations are terribly important. We spend a lot of time watching them.”²

What is the University of Michigan inflation expectations report?

While consumers react to what happens in the economy, they also react to what they think will happen. Expectations, like perceptions, can influence the country’s economic course and how the Fed reacts to it.

Each month, the University of Michigan surveys a nationally representative sample of approximately 600 adult consumers from the lower 48 states and Washington, DC. The survey asks a range of questions about consumers’ economic views of the present and future, as well as their opinions on interest rates, prices, incomes, expected purchases, and other factors. Participants are asked to give their answers in terms of better or worse (higher or lower) or the same.

As noted above, history has shown that inflation expectations can be predictive. Consumers expected high inflation in the late 1970s and early 1980s. Their spending habits then helped make it a reality.

What is the Federal Reserve Bank of New York Survey of Consumer Expectations (SCE)?

The New York Fed gathers information about what consumers believe education, food, gas, and housing prices — as well as general inflation — will do. It also looks at their views on future job prospects and earning potential and how those might affect their spending.

The SCE covers similar ground to the University of Michigan survey, asking participants to compare their lives in the past, present, and future. One key difference is in how possible answers are broken down. Participants have more options along the bad-to-good spectrum and are asked to give “the percent chance of something happening in the future.”

The SCE also differs in how it handles respondents. The survey is conducted online with a panel of 1,300 household heads who take part monthly for up to a year. The data that results from the same participants rather than randomly selected cross-sections allows for tracking how individuals view change over time.

What are breakeven rates and other market-based measures of inflation expectations?

Breakeven rates are a common measure of financial market inflation expectations. They are calculated by subtracting the yield on a nominal Treasury security from the yield on an inflation-protected security of the same maturity. This breakeven inflation rate represents the market’s expectation for inflation over the time period represented by the bonds’ maturity. For example, the difference in yield between a nominal 5-year US Treasury bond and a 5-year US Treasury Inflation Protected Security represents the bond market’s expectation of average inflation over the next five years.

The Cleveland Fed has developed a model of inflation expectations that is more comprehensive than simply looking at breakeven rates. It takes into account other factors, including the inflation risk premium.