We all see the trend toward rising interest rates, but how fast rates rise will likely come down to inflation. As the economy ramps up, investors should recall why inflation is such a risk. So, consider, if inflation takes hold, the Federal Reserve only has two remedies to stop it—deceleration and devaluation.
With deceleration, the Fed would hike rates to push down prices. Devaluation would also slow inflation, but would wipe out the value of every American’s savings at the same time. Given those consequences, we believe the Fed will unquestionably raise rates quickly to fight inflation.
We are already seeing signs of inflation which aren’t showing up in conventional measures. Today, the Fed utilizes the price index for core Personal Consumption Expenditures to measure inflation. I’ll refer to that as PCE. It switched from the Consumer Price Index, or CPI for short, back in 2000. Yet, today, PCE is muted compared to CPI. Why is this? Well, PCE measures what businesses are selling, while CPI measures what households are buying.
PCE covers more economic activity, but it’s not as sensitive to certain sectors that may indicate economy-wide inflation. Take shelter for example, which makes up roughly 33 percent of CPI, but less than half that for PCE.
But the bigger difference is scope, with healthcare a prime example. Medicare and Medicaid are both included in PCE, but not in CPI. Those costs are adjusted by the government, so using them to measure economic activity can mute the overall view of the market.
The Fed thinks PCE is more valuable because it covers more ground, but it’s covering parts of the economy that aren’t competitive. Prices of government-funded medical care won’t respond to monetary policy.
That’s why we look at CPI and other price and wage measures to pinpoint signs of inflation before they likely show up in the Fed’s preferred tool.