How do economists measure inflation, and why does it matter to investors?
The Federal Open Market Committee (FOMC) adjusts interest rates to
help keep inflation near a 2% target. The FOMC's preferred
measure of inflation is the Price Index for Personal
Consumption Expenditures (PCE), primarily because it covers a broad
range of prices and picks up shifts in consumer behavior.
The Fed also focuses on core inflation measures, which strip out
volatile food and energy categories that are less likely to
respond to monetary policy.
The typical American might be more familiar with the
Consumer Price Index (CPI), which was the Fed's favorite
inflation gauge until 2012. The Consumer Price Index for All Urban Consumers (CPI-U) is used to determine cost-of-living adjustments for federal income taxes and Social Security.
The CPI only measures the prices that
consumers actually pay for a fixed basket of goods, whereas the PCE tracks the prices of everything that is
consumed, regardless of who pays. For example, the CPI
includes a patient's out-of-pocket costs for a doctor's visit,
while the PCE considers the total charge billed to
insurance companies, the government, and the patient.
PCE methodology uses current and past expenditures to
adjust category weights, capturing
consumers' tendency to substitute less expensive goods for
more expensive items. The weighting of CPI categories is only adjusted every two years, so the index does not respond quickly to changes in consumer spending habits, but it provides a good comparison of prices over time.
According to the CPI, inflation rose 2.1% in 2016 — right in line with the 20-year average of 2.13%.1 This level of inflation may not be a big strain on the family budget, but even moderate inflation can have a negative impact on the purchasing power of fixed-income investments. For example, a hypothetical investment earning 5% annually would have a "real return" of only 3% during a period of 2% annual inflation.
Of course, if inflation picks up speed, it could become a more pressing concern for consumers and investors.
1 U.S. Bureau of Labor Statistics, 2017
(data through December 2016)