Measuring Inflation the Fed Way

Inflation has become a dominant theme in investment markets recently, but there is considerable debate over what measure of inflation is the best one. My fellow RealMoney columnist Barry Ritholtz has derisively referred to "core" figures as "inflation minus inflation" in the past.

But if you are thinking as an investor, the answer to the inflation debate is obvious. Inflation is what the Fed thinks it is. Period.

What do I mean? First of all, think about why you care about inflation, again thinking solely in terms of trading strategies. You care because inflation influences monetary policy and interest rates. You care because higher inflation will cause the Fed to hike rates, causing ripple effects throughout the economy.

Thinking in those terms, it's clear that the measure of inflation you should care most about is the same measure the Fed cares most about. Currently, that is core personal consumption expenditures (PCE). Some other measures are gaining popularity within the Fed, including the Median CPI, calculated by the Cleveland Fed and the Trimmed Mean PCE, calculated by the Dallas Fed. Both the Cleveland Fed President Sandra Pianalto and Dallas Fed President Richard Fisher are currently voting members of the FOMC. So if they care, you should care.

But what about rapidly rising food and energy costs? As far as the Fed is concerned, those cost increases result in an increase in the cost of living, but not inflation in the monetary sense. Remember that the Fed is in charge of the money supply. The theory goes that if every consumer suddenly had more money to spend (because the money supply increased) and the supply of goods were held constant, the price of all goods would have to increase.

Thinking about inflation in those terms, core-style measures make sense. And trimmed mean and median make even more sense. Because you are trying to measure a generalized movement in prices, not movements that are the result of specific supply and demand factors for a given good.

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At the time of publication, Graff had no positions in the stocks mentioned, although positions may change at any time.

Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.