How We Measure Inflation

By now, you have probably realized that inflation is a pretty big deal, and the economy can pretty much fall apart of it isn’t kept in control.  A major hurdle in keeping inflation under control is the problem of measuring it.  The best measures we have are computed on a monthly basis by the helpful folks at the Bureau of Labor Statistics (BLS).  The Consumer Price Index (CPI) is essentially based on a survey of businesses.  These businesses are asked about the cost of certain items.  These items are, of course, selected scientifically by the statisticians at the BLS.  Certain costs that have high volatility independent of the rest of the economy (i.e., uncorrelated volatility) are often removed from the analysis.

Another way to get at the idea of inflation is to examine what businesses pay for the materials that they need to manufacture products or otherwise conduct business.  The Producer Price Index (PPI) is a weighted index of prices measured at the producer level.  Current figures are released monthly by the Bureau of Labor Statistics (BLS), and investors watch the numbers carefully.  The PPI shows trends within the wholesale markets (the PPI was once called the Wholesale Price Index), manufacturing industries and commodities markets.

All of the goods-producing industries that constitute the U.S. economy are included, but imported goods are not included.  In other words, the PPI is specific to the economy of the United States as much as any country can be considered “independent” of the global economy these days.  The PPI can serve as a leading indicator of ultimate price changes at the consumer level, and of inflation if the trend in the PPI is higher.  Low inflation is good for stimulating consumer spending, corporate profits and ultimately the stock market.  Increased inflation can be a sign of an overheating economy and potentially higher interest rates.  Recall that the FOMC will “apply the brakes” if it perceives that the economy is overheating in this way.

Overheating

Overheating of an economy occurs when its productive capacity is unable to keep pace with growing overall demand.  It is generally characterized by a much higher than average rate of growth.  In other words, when growth is occurring at an unsustainable rate.  Boom periods are often characterized by overheating in the economy.


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