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.
A perfect example is the effect of ethanol requirements on food prices. Clearly ethanol is crowding out other food production, creating upward pressure on food prices. And yet this effect has nothing to do with the money supply and therefore isn't the Fed's problem.
Express all the outrage you want over the rising cost of living. As long as the Fed doesn't think it's their problem, it isn't going to influence their decisions. And if it doesn't influence their decisions, should it influence your trading? No.
The Fed will continue to be more concerned with the current recession and less concerned with inflation. Fed economists realize that it's difficult to get rising inflation without rising wages. It's simple supply and demand. If consumers don't have more money to spend, they can't bid up the price of goods. Hence, as long as wage growth remains tepid, we can conclude that food and energy price increases have to do with supply and demand in those markets and not generalized inflation.
What about M1, M2 or M3? Economists have soured on these measures in recent years, as changes in banking, as well as foreign holdings of cash, have rendered simple measures of the money supply invalid. But I'll indulge those who hang on to the classics. Let's assume the Fed prints $10,000 in new cash for every man, woman and child in the U.S. and just gives it away. But then all that cash just gets stuffed under mattresses and never sees the light of day. Do we have any inflation? Granted, this is a silly example, but it drives home the point: if consumers don't spend, we don't have any inflation. And consumers won't increase their spending unless they are seeing an increase in wages.
And we know the trend in wages: down. While job losses to date have been relatively minor, negative job growth is negative job growth. Besides that, the historical trend has been for job losses to continue even after the recession is over. I haven't even mentioned home prices yet. Consumers are going to remain pinched for the next one or two years, perhaps longer. It's just not too likely generalized inflation will accelerate given this backdrop.
Am I dismissing food and energy price increases as meaningless? No, just saying that rising prices in those markets don't have anything to do with money, and therefore won't influence the Fed's decisions. Want to do something about energy costs? Buy a hybrid car. Want to do something about food prices? Write your congressman. The Fed ain't going to help.
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.
