Financial Options

Consumers and first year economics students often have the same question about the reporting of inflation figures and it goes something like this: «Since food and energy are so important, why would I care about the inflation rate excluding them?» (I know because I actually asked it of my first year econ professor many moons ago.)

Advanced Personal Finance puts it like this:

Great! So if I don’t eat or consume any energy, my prices only rose 0.2%. What is a large chunk of peoples’ budgets? Housing, energy, and food. The core CPI is relevant for things like refrigerators and cars. When was the last time you bought a car or a refrigerator? How relevant, then, is core CPI? Not very.

Before I hit the major issues, I want to get the side issue of the relevance of cars, refrigerators, etc. out of the way. The CPI is a weighted index. To put it simply that means that the various items in the index are given more or less importance based on their share of the consumer budget. This is admittedly a simplistic way to explain it, but without going into the math it should suffice to say that the index takes account of both the fact that cars aren't purchased as often and the fact that they are major purchases when they happen. You may only make the car purchase every 5 years, but you probably make payments every month and that payment probably vies with energy, housing and food as a share of budget.

So, what about this core CPI? Why should investors look more closely at the core and pay less attention to the complete index?

• Food and energy are very volatile on a month-to-month basis.
• Increases in energy costs typically have some deflationary effect on the other components of the index.
• Increases in energy costs don't respond to monetary policy in the same way as the full CPI.
• Higher costs of these important components can have implications for corporate profit distribution.

Starting with the first and simplest, it's the month-to-month volatility that makes energy and food components less meaningful. In fact, since these categories may go up 5% or more in one month only to drop by a similar amount the next month, a single report's numbers on those components is nearly meaningless. To get any meaning, you have to look at the trend and the comparison to broader inflation. The core tends to reflect the longer run trend and the more volatile components on average end up conforming to the trend; over the longer term, the index trends for broad and core CPI tend to converge. Of course, the reporting of the broad inflation numbers may still move markets in the short run, but for investment (or even speculation) planning, understanding the trend is more important.

Advanced Personal Finance noted the deflationary effect of increases in food and energy costs, but thought this made the problem more pronounced. While this is perhaps true to some extent from a standpoint of consumer budgeting, it is not from the standpoint of the investor. For the investor, anything which tends to cause an overall deflation, or to reduce the amount of inflation, has one important effect - it changes the picture of potential Fed action on interest rates.

The unique effect of energy costs as such a vital resource is one that will really distinguish the savviest of investors. Historically, because energy costs are so important to the US economy, increases have led to unexpected economic effects, even supposedly «impossible» effects. Remember the «misery index» days of high inflation and high unemployment, a supposedly impossible mix according to the accepted economics of the day? When increases in oil prices were combined with an «easy money» policy, the result was stagflation - economic contraction and inflation combined. When increases in oil prices in a generally noninflationary economic situation are countered with the usual anti-inflation prescription - higher interest rates - the result is serious economic contraction, even the possibility of a full fledged depression. The Fed's monetary policy officials are well aware of the unique role of energy prices in the US economy and take it into account in formulating monetary policy. While oil prices certainly move markets, the savvy investor looks beyond the immediate to the interest rate implications and the implications for the business cycle.

The investor will also want to factor the cost of non-core components into his analysis of individual companies. Higher oil costs with lower core CPI can reflect an inability of corporations to pass along their higher energy costs to consumers. If tomato canneries have zero price increase while the price of tomatoes and distribution both increase, profits in the tomato industry suffer. Or consider a company which uses petrochemicals to produce synthetic fabrics and is unable to pass along the higher cost of petrochemicals or distribution.

Bottom line for CPI is that whether looking at the core or the full index, the investor needs to be looking beyond the single month figures for the larger trend and needs to consider the effects of the numbers on interest rates, corporate profits and consumer budgets. In the case of CPI, looking at the bigger picture means looking at the core and full indexes.

CPI,energy,gas prices,inflation