RateWatch #397 – Rates Down. Inflation. Remember That?

March 6, 2004 by Dick Lepre

What's Happening

Disappointing jobs numbers in the BLS Employment Situation Report have precipitated a significant Treasury rally. This may give us lower rates for at least a week or two. The data will, in
effect, alter the guesstimate as to when the Fed will start hiking.

The underlying problem is that, to folks who look at the economy, try to predict things and make investments based on those predictions the present economic situation makes little sense.  We should be better able to predict how many people are working.  Possible courses of confusion are: an increasing size of "cottage industries," off-shoring, and a loosening of correlation between what business says it intends to do regarding hiring and what it actually does. For today the news is good for the mortgage business and bad for Mr. Bush.

On Thursday afternoon I stopped at the corner grocery store on my way home.  The gentleman
there made a comment to the effect that people were not so confident about the economy and not
spending so much money and that it was Bush's fault.  I started to give one of my usual verbose
dissertations that the President and, indeed, all of Washington did not have as large an effect on the economy as believed and that the tax cuts had benefited GDP, but I was unconvincing. 
The one impression that I took away from that conversation was that I better understand why
political advertising is the way that it is. People who are influence by it do not have to
understand the totality of what is going on. They simply have to be convinced that by
checking one particular box on their ballot - things will be better for them.  Blaming
Bush for the jobs situation may be simplistic but it is also effective.


Since it is not really happening now but is always lurking in the background in any discussion regarding interest rates let's talk about our old friend - inflation.

The Measures of Inflation

By "inflation" we are almost always talking about CPI. But, there are other measures of inflation. Some of these are more forward looking than the backward looking, "this is what happened last month" nature of CPI.

Consumer Price Index (CPI)

CPI is a measure of the average level of prices of a fixed "market basket" of goods and services
purchased by consumers (food, clothing, utilities etc.). CPI is an indicator of inflation on the retail level.

This is calculated every month by the Bureau of Labor Statistics and available online at


The are 2 major CPI's:
CPI-U (U is for Urban) which represents about 80 percent of the total U.S. population. It is based on the expenditures reported by almost all urban residents, including professional employees, the self-employed, the poor, the unemployed, and retired persons as well as urban wage earners and clerical workers.

CPI-W is based on the expenditures of urban households that meet additional requirements: More than one-half of the household's income must come from clerical or wage occupations and at least one of the household's earners must have been employed for at least 37 weeks during the previous 12 months.  CPI-W represents about 37% of the population.

It is the CPI-U which everyone (including me) calls "CPI."

CPI includes:
Food and beverages (cookies, cereals, cheese, coffee, chicken, beer and ale, restaurant meals)

Housing (residential rent, homeowners' costs, fuel oil, soaps and detergents)

Apparel and its upkeep (men's shirts, women's dresses,jewelry)
Transportation (airline fares, new and used cars, gasoline, car insurance)

Medical care (prescription drugs, eye care, physicians' services, hospital rooms)
Recreation (newspapers, toys, musical instruments, admissions);

Education and communication (tuition, postage, telephone services, computers), and

Other goods and services (haircuts, cosmetics, bank fees)

CPI is seasonally adjusted to cull apart the changes that are seasonal from the underlying economic changes. Seasonal changes are fluctuations in prices which occur at the same time every year. They might be due to: automobile model changeovers, weather and holidays.  For example, gasoline costs more in the summer, tomatoes cost more in the winter.

The unadjusted data is what people actually pay. The adjusted data is what is reported in the media. CPI is a number that reflects prices with 1982-1984 averages as 100.0.  The adjusted index was 162.5 for April 1998 as compared to 162.2 for March so we say "CPI is +0.3%." CPI is based on a very large sample of goods in a very large sample of places.  The one criticism that can be made is that it takes no account for what people actually buy.  If, because of El Nino, tomatoes which cost $1.39 a pound in March now cost $4.59 a pound, people will diminish their purchases.  Because of this, CPI is, in terms of what people actually buy, slightly overstated.


PPI is the Producer Price Index  - this measures the average change over time in the selling prices received by domestic producers of goods and services. PPI's measure price change from the perspective of the seller. This varies from CPI which is a measure of price change from the buyer's perspective. Sellers' and buyers' prices may differ due to subsidies,  taxes, and the dynamics of distribution costs. 

Implicit Price Deflator

While CPI might be the "Dow" of Inflation it is, in essence, a measure of the price that people pay
for things and services.  The economy, however consists of a bit more than individuals.

A broad measure of economic activity is GDP (Gross Domestic Product). The GDP Implicit Price Deflator or IPD is based on the Gross Domestic Product and therefore reflects price changes in all goods and services transactions in the United States, including the consumer, producer, investment, government, and international sectors.  The IPD for GDP takes into account the price changes of the goods and services that actually happened. The IPD for the GDP is, thus,
a more meaningful measure of inflation than either CPI or PPI.

IPD might, for example, be used to adjust the cost of a long term projects such as Civil Engineering projects.  The EPA, for example, writes it into the bids for toxic cleanup projects. If one wanted to compare the economic impact of natural disasters from different periods, it would be appropriate to normalize the dollar losses at the time that the occurred using IPD's.


ECI is the Employment Cost Index.  When we were hearing about a tight labor market this might be where inflation would first show. ECI is the cost of labor on a fixed basket of occupations. This
eliminates the effect of the influence of employment shifts among occupations. While the average hourly earnings data would be affected by a shift in the occupational composition of the workforce and would appear as a wage gains, ECI would not be affected. Wages & salaries account for about 72% of the ECI. The rest is benefit costs.ECI data is available from BLS at:


FIG is a product of Economic Cycle Research Institute, Inc. This is a construct that is forward
looking.  It is a way to predict future inflation. The previously discussed indices take note of
inflation that has already occurred.  ECRI has a WWW site at  http://www.businesscycle.com This site is a, sort of, Bible on inflation. FIG is reputed to be able to predict inflation up to a year ahead.