Monday, September 11, 2006

What's the best inflation measure? Depends on who's asking.

I'm back from a brief hiatus. Our office has moved, and it hasn't left much time for blogging. Now everything is in place, and its back to work.

There is considerable debate on the blogosphere about what's the best inflation measure. There is CPI, Core CPI, Median CPI, Trimmed Mean CPI, as well as each of these in PCE form.

There are many who argue that core inflation understates inflation. If Joe Consumer has to pay more for gas, then his cost of living has clearly gone up. I think that's right. So if you are looking for a measure of cost of living increases, headline CPI is your number. That is a perfectly legitimate way of looking at inflation.

But if you are concerned with monetary policy, then better to take a monetarist's view on inflation. So if we assume...

P = M / Q

Where P is the price level, M is the money supply, and Q is the quantity of goods.

... then inflation (or change in the price level) is a function of the change in M and Q.

Economists try to measure M and Q directly, but for various reasons most economists agree that we can't get accurate enough results to calculate P from these figures.

So we have to try to measure P by observing market prices. But by looking at my equation, we see that if a change in P is caused by a change in M, all prices would be impacted similarly. Unfortunately, when we look at real market prices, we don't see them all moving in the same way. That's because each good is subject to its own supply and demand factors in addition to a universal money supply factor. If we are concerned with whether we have the right supply of money, then what we really want to do is isolate the money factor from the good-specific factors.

Here is where this logic train is heading. Obviously if you are trying to isolate the money supply factor, then taking a straight average of the prices of all goods doesn't make much sense. The average would be influenced by outlier prices, and we know the outliers must be the ones most impacted by good-specific factors. Take gasoline prices. Gas prices have risen in recent periods due to increased cost of inputs (oil) and supply constraints (e.g., refinery capacity shortages). This doesn't have much to do with a rising money supply.

Core CPI/PCE attempts to isolate this factor by ignoring food and energy, which tend to be quite volatile. That's a start, but it could well be that any number of prices are unusually influenced by good-specific factors.

So this leads us to the trimmed mean measure. This is where the most volatile PCE components are eliminated each month, regardless of what they might be, and an average is taken from the remaining. I think that's as close as we're going to get to isolating the money effect without going through some serious data massaging. Currently, the FRB of Dallas is keeping the measure. They've recently published a Power Point presentation on the subject, available here.

As you can see on page 21 of the presentation, the trimmed mean has been stubbornly high, suggesting to me that the Fed is more likely to at best hold rates where they are. Maybe the bond market is coming around to this way of thinking. The 10-year has fallen 3/4 of a point in the last 6 trading days.

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steve feiss said...

Tom, I don't mean to be a haunt. I am very impressed with your thought process in this last post. Honestly I can hardly spell any of those things, let alone fully grasp their meanings nearly as well as you do. I can however say that there has been more to the recent downtic in the Treasury market than fearing the Fed's view of Trimmed Mean CPI. Corporate supply calender as you probably know, has been gi-normous and we've been in a data void. Europe has been (in my humble opinion) in the lead spot ... the tail waggin' the dog (?) if you will, constantly bombarding the capital mkts with further tightening talk. UK keeps posting strong econ data as well. SO, supply, strong global data and Range-zilla have had a bit to do with the recent mkt downturn. Interestingly enough, gotta point out that after a few days of respecting the 'top' of the range, trending lower by 3/4pt, we snapped back most of that over the course of the last 12hrs post 10yr re-opening!

Interestingly enough, I find myself agreeing with you more than not. Please understand that ... love curve steepening idea (core longer term position). Today's notion of Fed on hold (happens when we are transitioning from tightening to easing, agreed?). I just can't help but wonder after reading this recent post, IF the Fed was thinking about coming back in off the bench, and tightening, given Bernanke is so darn transparent, you'd think we'd have heard something like this from some of the Fed-speak over the past few days. Maybe we did, and I missed it and THAT's why the longer end of the curve trades so well (Land of the Big '01s LOVES a Fed that's fightin' inflation, right?)??

OTHERWISE, did want to mention something else we are hearing from OUR clients and colleagues, is the current meltdown in commodity space having been largely behind recent mkt UPtic (post 10yr auction yesterday). Should help contain inflation which would help the Fed move to the sidelines sooner rather than later. Interesting. Seems to me the other side of that coin is it should also help consumers and corporations alike who've been penalized with higher energy costs. Curious where you might stand on this one ...

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