I am very concerned about inflation and this is a theme that I plan to be coming back to it regularly. Here, I want to first give, for those who are not familiar with, some definitions of inflation and then to introduce a class of assets that provide (perhaps) a hedge against inflation, the Treasury Inflation-Protected Securities (TIPS). The reason is to clarify some differences among different inflation measures and where perhaps each of them is used and also to dispel the misunderstanding that exists with respect to which measure of inflation do TIPS use and more specifically whether food and energy prices are included in it.
Unfortunately, there are many inflation measures and they differ on the composition of the asset basket for which prices are used in order to find the level of the Price Index, which then will result to the corresponding inflation measure. Inflation is the rate of change of the Price Index of each corresponding basket. Usually inflation is measured in a monthly frequency, as it is not feasible and perhaps it is not necessary to measure at a higher frequency.
The two inflation measures that matter for us are the Core Inflation and the Headline Inflation (CPI-U). What matters for us, as consumers, is the Headline Inflation because it incorporates the prices of more consumption goods – and goods that are broadly used – than the Core Inflation. Notably, the Core Inflation does not include food and energy prices. This is done because their prices are more volatile and they are more susceptible to short term supply shocks that can make a measure that includes them deviate substantially in the short term from a long term trend. Economists, and especially FED macro-economists, who want to gauge inflation dynamics in order to form monetary policy, need to base their policies on stable price trends and not on transitory effects, filter out these deviations – or “noise” around the trend – by focusing on the Core Inflation measure.
Why does the FED focus on Core CPI?
Different websites and even popular press takes this wrong hinting on negligence or conspiracy. The truth is far from that. The answer is that transitory deviations from the true CPI trend would give a lot of false signals to the monetary authorities and this would result to a huge distraction of value in the economy. This can be understood better with the help of the following example that I borrow from an anonymous source.
Suppose that the Federal Reserve had a mandate to stabilize the full Consumer Price Index, and that food prices suddenly doubled. To keep the CPI at a stable level, other prices would need to decrease. The problem, however, is that many prices are sticky, meaning that they do not instantaneously respond to changes in monetary and macroeconomic conditions. This is especially true in the service industry (which comprises the bulk of both GDP and the CPI).
To create these compensating price changes within a relatively short timespan, the Fed would have to impose extremely tight monetary policy, with sky-high nominal interest rates. And as we saw in the early 1980s, a large increase in nominal interest rates is extremely destructive to the real economy, leading to a massive increase in unemployment. Given our already weak economic conditions, such a policy would be even more damaging today.
Core CPI is a way to prevent this kind of needless suffering and unemployment. By targeting a more stable set of prices, the Fed avoids the wild swings in monetary policy that would inevitably arise from targeting an index that includes commodity prices. In other words, the demagogues who assail core CPI have it all wrong: the average American would be much, much worse off if the Fed targeted a volatile measure like headline CPI.
For more on CPI’s and their performance see here, here, here and here.
What are TIPS?
TIPS are Treasury Inflation-Protected Securities. They are bonds that have a fixed interest rate (coupon rate) which is determined at their auction, but they differ from Treasury bonds, in that their face value fluctuates positively one-to-one with the CPI. What I want to clarify here that is confusing to a lot of people is what is the CPI measure that is used for the face value. Several people spread around that this is the core CPI which is not correct. It is the CPI-U or Headline CPI that is used – that includes food and energy – in order to compute the TIPS face value. This is stated explicitly on the Treasury’s website. A question one may have is how does the Treasury come up with the future face values since they announce ahead of time the Daily Index Ratio for the next month. The answer to that is that they do a three month rolling average, extrapolating for the next one month period. The interesting remaining question is, how do they come up with daily CPI-U? I will respond to that when I find the answer.
To conclude, there is no cheating in the way TIPS have been constructed, as the belief that TIPSs face values do not reflect real inflation is not correct.
