Unexpectedly Intriguing!
28 November 2023
A picture illustrating the concept of prices rising over time. Digital art, 4k. Source: Microsoft Bing Image Creator

Inflation indices like the Consumer Price Index (CPI) and the Producer Price Index (PPI) have been in the news a lot since inflation began running hot in the spring of 2021.

As their names suggest, these seasonally-adjusted indices provide a measure of the inflation experienced by different groups within the U.S. economy. The CPI represents the measure of inflation experienced by all U.S. urban consumers (about 93% of the population) and the PPI measures inflation experienced by U.S. businesses that either produce goods or provide services.

The Bureau of Labor Statistics reported what was considered to be positive news for both the CPI and the PPI inflation indices for the month of October 2023. The CPI was unchanged from its reported level in September 2023, although it was up 3.2% year-over-year. The PPI "unexpectedly" fell by 0.5% from its September 2023 level, but was still up by 1.3% year-over-year.

How is this information less than useful? To understand why, try answering these two questions using the information presented in the previous paragraph:

  1. How will the CPI and PPI change from October to November 2023?
  2. How will the CPI and PPI change from October 2023 to October 2024?

If you're in the business of looking forward, as many analysts and business managers have to be because they're making decisions and plans about what to buy or what multi-million dollar investments to make, this information tells you virtually nothing about where inflation is heading. Their getting the answer wrong can cause big losses and/or jobs.

In 2010, money manager Barry Ritholtz slammed the CPI in particular and explained why to Time's Justin Fox:

Another we have to look at as not helpful at all is CPI. Thanks to the Boskin Commission, it has been rendered more or less meaningless. He (economist Michael Boskin) deserves credit for taking an otherwise valid economic indicator and pissing all over it. (Here’s Barry going on at length about his disdain for Boskin.)

Meanwhile, Moody's economist Mark Zandi faulted the usefulness of the PPI, grouping it with other economic indicators he described as "either often misleading or the signal to noise ratio is very high and thus hard to interpret". (Note: That's a verbatim quote. Zandi most likely meant the noise-to-signal ratio was very high for the indicators he cited, as that would be a bad thing for getting a good reading on the direction of the economy.)

Speaking of which, did you know the Federal Reserve, which is chartered with the jobs of providing for price stability and maximizing the number of jobs in the U.S. economy, doesn't have a good understanding of inflation? Here's how former Fed governor Daniel K. Tarullo put it in a 2017 paper:

The substantive point is that we do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policy-making.

It's not like the Fed doesn't have inflation data, as the CPI and PPI are just two measures of it. But it's clear doing anything useful with the information provided by the inflation indices is something of a problem for the people who have to be the most on top of it.

The CPI and PPI data reported to the public feeds into future expectations for inflation, and as Barry Ritholtz colorfully put it earlier this year, "inflation expectations are useless":

They aren’t merely lagging, backward-looking indicators, but instead, inform us as to what the public was experiencing about 3-6 months ago. Typically, it takes people a few weeks or months to subconsciously incorporate broad, subtle changes into their internal mental models, and longer to consciously recognize those nuanced shifts.

Beyond short-term trend extrapolation, inflation expectations have little to no ability to provide insight into the intermediate-future (e.g., 6-12 months) inflation. As to the longer-term, the 5-Year Forward Inflation Expectation Rate are ridonkulously, hilariously, laughably useless. They are so silly as to be “Not even wrong” — just goofy irrelevant guesses.

Meanwhile, Bloomberg Markets' Mark Cudmore takes aim at another frequently reported measure of inflation expectations that doesn't track with the CPI:

The inflation expectations reading from the University of Michigan is again being cited as a relevant input. It’s not. Anyone who is allowed to touch any of the real buttons in a trading room should ignore it.

It’s completely useless, not just as a guide to levels, but even directionally. No amount of data-mining can validate any useful signal from the reading since the inflation regime changed several years ago.

A 2021 paper by the Federal Reserve Board's Jeremy Rudd confirms the Fed's analysts have little-to-no confidence in the inflation expectations data.

Economists and economic policymakers believe that households’ and firms’ expectations of future inflation are a key determinant of actual inflation. A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors.

As economic indicators, inflation indices are backward-looking metrics that are not useful for divining where inflation will go in the future. To the extent they are useful, it is as a means of quantifying how prices changed in the past. Inflation expectations data doesn't even have that going for it.

Previously on Political Calculations

Image credit: Microsoft Bing Image Creator. Prompt: "A picture illustrating the concept of prices rising over time. Digital art, 4k."


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