It’s common knowledge that central banks often base their interest rate decisions on inflation figures. While it’s not the only data they take into account, stabilizing their respective currencies is still their primary purpose. In a sense, this means whether or not they can meet inflation goals is an indicator of how effective their efforts were. This may all seem fairly straightforward. However, in reality, inflation isn’t a single piece of data. It’s actually a combination of several standardized portfolios, and their results can often vary considerably.
Core inflation, Consumer Price Index, and the GDP deflator are the three key figures that seem to attract the most attention. News sites and journals that care about macroeconomic trends rush to print or publish them as soon as they release. Traders often keep an eye on these figures too. However, they rarely ask themselves the most important question: Which one of them is the most relevant to my own investment strategy?
US inflation was 1.5% in February of 2019. Core inflation was 2.1%, and the GDP deflator from 2018 showed 111 points. Which of these three is actually relevant for determining whether there’s going to be an interest rate hike? The only way to answer the question is by taking a closer look at what these numbers actually entail.
The GDP deflator is the most unique of the three inflation types. That’s because we don’t measure it in percentages. We calculate it by dividing Nominal GDP with Real GDP and then multiplying the result by a hundred. In essence, it shows the overall change in the prices of a given country’s total assets, including investments, but excluding changes in import prices. It’d be logical to assume that national banks consider this the most relevant metric. However, in reality, it lacks detail. It paints in broad strokes and fails to account for specific internal changes in price structure. This characteristic makes it of little interest to currency traders.
On the other hand, it’s a great deal more useful to index traders. When the vast majority of companies are present on the stock market, the GDP deflator can serve as a useful indicator of how well the entire domestic market performs. The only drawback is that it’s only published quarterly and typically only after the Flash Report season. This does limit its utility as a measure of inflation.
Consumer Price Index
Central banks don’t get much mileage out of the GDP deflator either. They prefer a faster and more specific figure. Their go-to is the Consumer Price Index. It makes a great deal of sense when you consider the effect price stability has on the populations’ propensity to spend. That, in turn, affects GDP. Statistical bureaus compile it by taking a fixed bundle of hypothetical goods considered representative of the market. Afterward, they compare those prices on a month to month basis. This data allows us to determine whether the purchasing power of the population’s savings grew at the same rate as their cost of living. If the interest on savings accounts and the yields on low-risk treasury bonds are lower than inflation, then the real value of the population’s capital decreased. Even if its nominal amount increased. As inflation rises, capital held in low-interest investments falls.
The opposite is also true. Changes in the market price of long-term treasury bonds accurately reflect the populations’ sentiment about inflation. Treasury bonds are a notable segment of the money market and they’re extremely sensitive to changes in real returns. Interests on newly released bonds are often set with inflation in mind rather than base interest rates.
There’s also the third kind of inflation data known as core inflation. It’s the result of statisticians attempting to refine inflation figures by removing changes based on unavoidable or one time occurrences. The method is simple, just remove certain products from the hypothetical basket of products you use for calculating inflation. These removed products include basic necessities such as fuel and household utilities or products with regulated prices such as medicine. This tells us that core inflation isn’t for the general population but rather experts interested in examining underlying trends in the economy. The latter includes central bankers since it shows the products most affected by their interest rate policies. It’s what forms the basis for determining their inflation targets.
The US population only experiences a 1.5% inflation, however, that’s mainly due to low oil prices and cheap imports. Once you remove those from the equation it becomes 2.1% instead. This latter number is the one on the Fed’s mind. That’s because they’re less concerned about the product market and more interested in keeping the economy robust. Compared to a 2.1% inflation rate, their 2.5% base interest rate doesn’t seem at all unreasonable. Even if it comes with its own downsides.