HomeUnderstanding Inflation Through a Central Bank’s Eyes

Understanding Inflation Through a Central Bank’s Eyes

Traders’ fears of inflation have been fueled lately by rising commodity prices, yet the median CPI year-over-year is declining.

The US Federal Reserve left its monetary policy unchanged yesterday. The event was closely monitored by traders around the world; especially the press conference which gave Fed chairman Jerome Powell a chance to explain the Federal Open Market Committee (FOMC) decision.

One major topic was inflation. The Fed changed its mandate during the pandemic, from targeting 2% inflation (last year in August) to targeting “average” 2% inflation.

People are becoming increasingly concerned about inflation, which usually starts with commodities as the traditional hedge against inflation. Lumber and housing prices are at all-time highs. Food inflation is at a seven-year high. We see these numbers every day, yet Fed’s CPI inflation number is at a seven-year low. And falling. How is that even possible, and what does it mean for future monetary policy?

Understanding Inflation

Inflation is one of the first economic concepts a financial market trader should grasp. Also known as the Consumer Price Index (CPI), inflation shows the change in the prices of goods and services over a period. It is calculated monthly so that analysts, researchers, and market participants can track and interpret it.

When rampant inflation leads to hyperinflation — as seen in Argentina, Venezuela, and Turkey over the years — money dies.

Rising inflation (but at lower growth rates) is called disinflation.

Finally, when inflation turns negative, it is called deflation.

Deflation is the one that central banks fear the most as it is the most difficult one to deal with.

The problem arises from the way inflation is calculated. Like any index, it depends on what is in the basket. CPI is based on prices for food, clothing, shelter, and fuel. Many subcategories are excluded, and prices are collected monthly from a few thousand households across over eighty urban areas. That’s it.

What does it have to do with regular household expenses? Pretty much nothing. A recent study among American adults shows that less than 2% are not at all concerned about rising household expenditures. Anyone with kids in school knows that education costs are through the roof, and so is healthcare, yet these prices are excluded from the inflation calculation.

In summary, before arguing that the Fed should act as prices are rising, be sure that you’re thinking about inflation in the same way that the Fed does.

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