Inflation: More For Less and Less For More (Part 1)

Given the significant amount of current discussion in the financial press around inflation and on the impacts on our recovering economy, this month and next month we’ll take a look at how we measure inflation and some of the issues it raises for financial institutions and credit underwriting professionals in this article, Inflation: More For Less and Less For More.

As a kid growing up, I would pick up bottles along the road for the deposit money, which I would promptly “re-invest” back in the economy in the form of penny bubble gum or nickel candy bars (a real-life example of the velocity of money). Snickers candy bars were my favorite! At one point I noticed that the candy bar seemed to be getting smaller, or I had to pay a lot more for a bigger one. When I asked my dad – the source of childhood wisdom – he informed me that what I was seeing was called “inflation.”

“What is that?” I asked. “Well, son, that is paying more and more for less and less.” Genius!

Well, nothing can stay that simple, so we now have advanced education curriculums to study this phenomenon called Economics, and most economists agree that inflation occurs when the growth in the money supply out paces economic growth. The measurement used to quantify this change is the inflation rate, which is the percent by which the value of currency is falling, and the general level of prices of goods and services is rising.

That seems easy. Not so fast! There are numerous measures that are used to analyze this situation with differing results. Here’s a brief look at some of the most common measures.

CONSUMER PRICE INDEX (CPI)

Prepared by the Bureau of Labor Statistics, this is probably the most widely used and watched index. It compares the relative cost of approximately 80,000 products and services in 200 broad-based categories. The three largest are housing (41%), transportation (16.8%), and food and beverage (15.3%). Today, economists even disagree on this calculation. Originally based upon a cost of goods index (COG) with a fixed basket of goods with a fixed quantity and quality, it is evolving to a cost-of-living index (COLI) designed to take into account changes in consumer purchases (substitution) in response to price changes.

Think beef as a category. When times are good, I buy steak at $20 per pound; when they are not so prosperous, I buy hamburger at $5 per pound. If I reduce my purchase of steak by one half and increase my hamburger by 3 times, there would be no change in the CPI as measured by cost of living. No cost difference to me; probably a big difference for the cow. It is important to note that in both COG and COLI cases, the calculation covers only out-of-pocket expenses on goods and services. It excludes costs not directly paid by the consumer such as employer-paid medical insurance, Medicare, and Medicaid.

PERSONAL CONSUMPTION INDEX (PCI)

This is prepared by the Bureau of Economic Analysis (BEA). It is like the CPI in its use of a “basket” of goods and services. However, there is a difference in the goods and weighting in the calculation.

PERSONAL CONSUMPTION EXPENDITURES (PCE)

Prepared by the U.S. Bureau of Economics (BEA), the PCE is a measure of national consumer spending on goods and services. The goods category consists of two components: durable goods such as autos, washers, and dryers, etc., and non-durable goods including household items such as groceries and clothing. Services may be items provided by third parties including maintenance and repairs, childcare, financial services, etc. Services may be provided by businesses or government. A subset of this index called the Core PCE excludes costs for food and energy and is closely watched by the Federal Reserve in managing monetary policy.

GROSS DOMESTIC PRODUCT PRICE INDEX

This is prepared by the BEA. It is based upon the prices paid for goods and services produced in the United States including export items. However, it excludes prices paid for imports.

GROSS DOMESTIC PURCHASE PRICE INDEX

This is the featured index for the BEA. It includes the prices paid by consumers, businesses and governments in the United States including imports they may purchase.

WHOLESALE PRICE INDEX (WPI)

This is released each week by the Office of Economic Advisor. It measures and tracks changes in prices of 435 commodities/goods primarily sold in bulk between businesses (not consumers).

As can be seen from the above, there are subtle (and some not so subtle) differences in each of the calculations. It be confusing (and, perhaps, overwhelming)! It also can be used to tell a “story”. The consistent theme of the story, however, is that we will be paying more and more for less and less. Maybe we will just be getting less and less for more and more!

In next month’s conclusion to our discussion on Inflation: More For Less and Less For More, we will look at some of the current causes of observed inflation and potential challenges for lending institutions and commercial credit professionals.

Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape. We lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133.