There’s a new inflation story every day, but that doesn’t mean investors are any closer to making sense of it all.
For one, the varying measures of inflation – and all of the categories and sub-categories that go along with it – are nothing short of head-spinning. Most readers have heard of the commonly cited Consumer Price Index (CPI), but that’s not even the measure of inflation the Federal Reserve uses when making policy decisions. The Fed focuses on the Personal Consumption Expenditures (PCE) price index, and these days the central bank also seems to prefer stripping out food, energy, goods, and shelter (housing).1
All told, the Atlanta Federal Reserve tracks nine inflation indices that all use slightly different methodologies to measure “underlying” inflation. As you can see below, the results often vary widely, painting significantly different inflation pictures depending on which metric is being used:
| Measure of Underlying Inflation | 12-Month Growth Rate (December 2022) |
| Core CPI | 5.7% |
| FRB Cleveland Median CPI | 6.9% |
| FRB Cleveland 16% Trimmed-Mean CPI | 6.5% |
| Atlanta Fed Sticky CPI | 6.7% |
| Core PCE | 4.7% |
| Market-Based Core PCE | 4.9% |
| FRB Dallas Trimmed-Mean PCE | 4.6% |
| FRB San Francisco Cyclical Core PCE Inflation | 7.5% |
| Cyclically Sensitive Inflation (Stock and Watson (2019)) | 6.7% |
In any given year, as an investor determines their outlook for inflation, interest rates, and corporate earnings, using CPI and Core CPI is likely satisfactory for the inflation piece of the analysis. But I’m not sure that works for 2023.
This year, I think investors should focus on what the Federal Reserve is focused on. Minutes from the December Fed meeting – in addition to numerous comments and press conferences from Chairman Jerome Powell – say the focus should be core services inflation excluding housing. In other words, while analysts and experts are breaking down changes to the prices of eggs, gas, and refrigerators each month, investors can likely look past these commentaries and data points. At this stage, “goods inflation” is not bearing nearly as much weight on the Fed’s thinking as many investors and market watchers may think.
Last month, for instance, CPI fell to 6.5% in December from 7.1% in November and a peak of 9.1% in June, and overall consumer prices also fell -0.1% in December from November – the first monthly drop since May 2020. The Fed was largely unmoved. That’s because core services inflation (blue line on the chart below) remains elevated even as broad-based measures of inflation are in a downward trend.
Services Inflation Excluding Housing (Blue Line) Remains Elevated
Services inflation is driven in large part by a tight labor market’s effect on wages. That means investors’ approach to inflation this year should involve monitoring average hourly wage data, as well as keeping an eye on the Bureau of Labor Statistic’s employment cost index release. These are the inflation metrics the Fed is watching most closely to determine the path of interest rates, so it makes sense that investors should be honing-in on this aspect of inflation, too.
Bottom Line for Investors
December 2022 wage data was encouraging. Year-over-year, wages rose by 4.6%, a marked improvement from a 5.6% peak in March but still not compatible with the overarching goal of 2% core inflation. Looking at just Q4 2022, wages grew at a 4.1% annual rate, which may be confirmation that a softening trend is firmly underway.
Later in January, the Labor Department will release its quarterly employment-cost index, which is not likely to receive much press but that investors should keep a close eye on. The Fed sees this index as the most reliable gauge of worker pay, so it is likely to factor heavily into their plans for interest rate policy. Better data on wages could offer a clearer understanding of where interest rates will peak, which many would argue is what the stock market needs for a sustained rally.
Disclosure
2 Federal Reserve of Atlanta. 2023. https://www.atlantafed.org/research/inflationproject/underlying-inflation-dashboard
3 Fred Economic Data. January 13, 2023. https://fred.stlouisfed.org/series/USACPGRLH01IXOBM#
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