Here’s to Your Wealth – Demystifying the Inflation Numbers Driving Markets and Your Wallet

Over the last few years, there has been no shortage of stories, articles, and headlines about inflation. The International Monetary Fund defines inflation as “the rate of increase in prices over a given time period,” (Oner, para 2). There are two main sources of economic data that attempt to track inflation: Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE). CPI is found more often in the various news and media outlets. The Fed, when determining interest rates, looks more to PCE. This month, we will explore each of these measures, how they are calculated, and the differences between them. Additionally, we will discuss their significance in both monthly and year-over-year data, and their impact on the economy and stock markets.

One thing that can be confusing for people is when the media reports that inflation has decreased. Some wonder how that can be possible when everything still seems so expensive. That is because price levels are not coming down; they are just not increasing as quickly. CPI and PCE both measure the rate of change of prices, not the absolute price level of goods.

The graph below from the St. Louis Federal Reserve plots CPI (blue line) and PCE (red line) from 1980 to 2022. Note how the overall trend for both lines is similar.

CPI is a widely used measure of inflation that tracks changes in the average prices paid by urban consumers for a market basket of goods and services over time. CPI uses a fixed basket of goods and assigns fixed weights to the items. PCE is more flexible. It adjusts its components and their weightings over time to reflect consumers’ changing spending habits, making it a dynamic and adaptable measure of inflation. Both CPI and PCE report changes relative to a base year. The base year has a value of 100. If, in the following year, the index has a value of 105, then inflation has risen by 5%.  Because CPI is more fixed, and PCE is more dynamic, PCE is thought to be more reflective of changing consumption patterns.

Both CPI and PCE collect data monthly. Monthly inflation data can provide insights into short-term price movements and can be volatile. Year-over- year data smoothens out the volatility and offers a better gauge on longer- term price trends.

So how does inflation data impact the economy and financial markets?

• Monetary Policy: Central banks use CPI and PCE data to inform their interest rate decisions. High inflation can spur central bankers to hike interest rates which may have the effect of curbing price increases, potentially affecting economic growth and stock markets.
• Investor Sentiment: Stock markets often react to CPI and PCE releases. Higher-than-expected inflation can lead to market volatility as investors worry about reduced purchasing power and potential interest rate hikes.
• Consumer Behavior: If the rate of change of prices is rising, this can lead to reduced spending and adjustments in consumption patterns, impacting various industries.
• Business Decision-Making: For businesses, understanding CPI and PCE data is crucial for setting pricing strategies, wage negotiations, and budget planning.

Both indices provide valuable insight into inflation trends, which in turn can impact economic policy, financial markets, and personal spending decisions. By measuring the rate of change in prices, it allows us to track shifts in purchasing power and adapt our financial strategies accordingly.

While we can’t know for certain what future price levels will be, we can track changes in price trends using CPI and PCE. We do know that maintaining the right portfolio mix is essential to preserve and grow wealth over time. A well-diversified portfolio helps mitigate risks associated with “the unknowns,” and a disciplined process helps ensure that our focus is on controlling the controllables.

Wishing you good health and good wealth.

References:
Oner, C. (n.d.). Inflation: Prices on the Rise. https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Inflation

Michael St. Onge, CIMA®, CPWA®
Senior Vice President
Wealth Advisor
[email protected]
603.527.3234

This material is intended for informational/educational purposes only and should not be construed as tax, legal or investment advice. We make no representation as to the completeness or accuracy of information provided at these websites. Please consult with your financial professional and/or a legal or tax professional regarding your specific situation and before making any investing decisions.

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