Part 2

How Is Inflation Measured?

In the previous part of this series, we discussed what inflation is, why policy makers try to manage it, and what can happen when they fail to do so. But we skipped over an important question: how is inflation measured?

Speaking generally, inflation is measured by tracking a representative sample of the prices of various goods and services across industries. The three most commonly used trackers of inflation in the U.S. economy are the Consumer Price Index (CPI), the Producer Price Index (PPI), and the Personal Consumption Expenditures (PCE) price index. 

Consumer Price Index

Perhaps the most widely known measure of inflation is the Consumer Price Index, or CPI. In fact, our Washington Policy Strategist Tom Block frequently reminds us that, outside of the fields of economics and finance, many – including members of Congress – are unaware that any other measure of inflation even exists.

CPI is calculated by the Bureau of Labor Statistics (BLS). BLS economists and employees collect sample prices for a fixed basket of goods and services, as might be purchased by the average American consumer – as many as 94,000 data points each month. The majority of these prices are obtained through personal visits to brick-and-mortar stores, with the remaining information collected through phone surveys, websites, and e-commerce apps. The BLS also collects about 8,000 instances of prices for rented housing.

The data is weighted based on consumer surveys on household-budget allocations to various categories (housing, food, fuel, travel, etc.) This weighting is adjusted roughly every two years to account for changes in spending habits, which might include the introduction of new products and services, and the obsolescence of others (e.g., landline phones, VCRs, and film processing.)

The index itself is referenced to 1982-1984 prices (so a CPI of 300 means prices are about triple their levels in 1982-84). Most observers are more interested in the rate of change, either month over month (MoM) or year over year (YoY). It is common for many investment strategists and economists to focus on Core CPI, which strips out the more volatile food and energy prices; proponents argue that Core CPI gives a truer view of how consumer prices are changing. 

Detailed information about CPI can be found here:

Producer Price Index

As the name suggests, the PPI focuses on how inflation affects producers rather than consumers. As such, it focuses on wholesale prices rather than prices at the retail level. Like the CPI, PPI is calculated by collecting data on a basket of goods and services. The PPI basket also includes non-consumer-focused categories – raw materials, machinery, intermediate goods (e.g., components), wages, etc. 

Because of its focus on producers, the PPI is viewed as a leading indicator of consumer inflation. After all, if producers see a sustained period of higher prices, it is likely that they will eventually pass those price increases on to their customers. 

Detailed information about PPI can be found here:

Personal Consumption Expenditure (PCE) Price Index

As the name implies, PCE also measures inflation from the perspective of a consumer, just like CPI. CPI and PCE used different formulas and methodologies, and many economists believe that the PCE’s methodology allows it to more quickly reflect changes in consumer spending habits, including those made in response to inflation. For example, during instances of challenging economic conditions such as rising inflation, PCE will reflect the consumer shift from beef to chicken, a less expensive alternative, more quickly. 

The two metrics use different data sources and methodologies. CPI focuses on out-of-pocket expenditures, estimated based on household surveys. PCE relies on prices paid for consumer goods or services, even if the consumer is not directly paying out of pocket. For example, PCE takes into account the total sum paid to providers (including by insurers) for healthcare services, rather than just the sum the consumer pays out of pocket. While politicians focus on the CPI, the Federal Reserve’s preferred inflation metric is PCE. Both are important for investors to track. 

Consequently, while the BLS largely relies on surveys of consumers to obtain data used in CPI, the Bureau of Economic Analysis (BEA) examines data about what businesses are charging at the consumer level for various goods and services. 

Detailed information about PCE can be found here:

The FS Insight Perspective on Inflation

Fundstrat Head of Research Tom Lee and his team perform regular deep dives on all three of these inflation indicators, examining not just Headline Inflation and Core Inflation, but also the individual components that go into calculating these indicators and the data that the BLS uses, getting granular whenever needed.

Consider CPI, for example. On October 12, 2023, September Core CPI came in more or less in line with Street expectations. However, when looking at the BLS’s data, Lee and his team noticed a startling detail: “The largest contributor to the rise in Sept. Core CPI was shelter,” Lee wrote in his Intraday note, “and more specifically, ‘lodging away from home,’ which is hotel stays.” This accounted for about 30% of Core CPI – a huge percentage from a single line item. 

The hotel component of CPI rose +4.21% MoM – a 51% annualized rate. That is to say that from August to September, hotel prices rose at an annualized rate of 51%. “Does anyone really think hotel prices [rose that much] in September? This doesn’t make sense,” Lee argued.

How Is Inflation Measured?
Source: Intraday Alert from Tom Lee, October 12, 2023

So Lee put his team to work, examining not just BLS data, but also data from industry sources. They found that much of this increase had to do with a surge in hotel prices in just one place – New York City. 

How Is Inflation Measured?
Source: Intraday Alert from Tom Lee, October 12, 2023

The team did not reach a conclusion as to why, but the working theory was that a new change in New York City regulations regarding short-term vacation rentals (think AirBnBs) caused a short-term slump in supply of temporary lodgings, and thus an increase in demand for hotel rooms. The FS Insight team also suggested that this increased demand might have been exacerbated by an influx of migrants being housed in hotels.The cause was unimportant in this context: Lee and his team correctly concluded that the Federal Reserve was unlikely to hike rates in November and December due to what turned out to be a spike in NYC hotel prices, and that consequently, that markets could rise into the end of 2023.

In our next installment, we will discuss some causes and contributing factors of high inflation, and what policymakers can do in response. 

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Inflation – What’s All the Fuss About?
3 Lessons
~15 mins in total
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