Inflation – Much Ado About Nothing

| October 21, 2010 | 0 Comments

Well I was right… sort of.  Last week I highlighted a key economic indicator – CPI, and why you should watch it closely.  I also predicted the CPI would be positive for the month of September. And CPI was positive… as I predicted… but just barely.

September CPI showed a 0.1% increase from August levels.  So, consumers experienced an overall 0.1% price increase last month. Like I said, positive… barely.

Last week I also mentioned inflation concerns may start to surface.  However, it doesn’t appear to be the case.  You see, while CPI for September was positive, Core CPI was flat.

I’ve gotten a lot of questions from readers.  Many are wondering what the difference is between standard CPI and Core CPI.  So let me take a minute to discuss these two different measures.

Remember, standard CPI is an index which measures the change in prices of around 200 goods and services.  Those 200 items are divided into eight different categories weighted by spending importance.

In a nutshell, Core CPI removes food and energy from the calculation.  That’s a pretty big deal. Food and energy make up about 25% of the CPI measure.  So why remove such a big piece of the equation?

The thing is, food and energy can be very volatile on a short-term basis and may skew the CPI number too far up or down from month to month.  This short-term volatility could mask the true underlying trend in prices.

Rumor has it, the Fed uses Core CPI as a gauge of what inflation’s doing.  That’s why CNBC usually makes a big deal about Core CPI and not standard CPI.

But here’s the thing…

The media puts too much emphasis on Core CPI as a measure of inflation.  What the Fed looks at is absolutely going to be different than what consumers look at.  But… you and I are consumers.

In other words, standard CPI is far more relevant to us.

Unless something has changed since I started typing this article, consumers still buy food and gasoline each week.  So why wouldn’t we be concerned about those prices?  In fact, I’d say on a monthly basis, we’re most concerned with food and energy.

You know what’s interesting… the difference between Core and standard CPI is mostly a short-term variation.  Over the long-run the difference between the two types of CPI is less than 1%. That doesn’t seem like a big deal to me.

Bottom line, both types of CPI are important, but standard CPI is the one for you and I to keep an eye on.

Let’s get back to the big picture…

Whether you’re looking at standard or Core CPI, inflation doesn’t appear to be a looming concern… yet.  On the other hand, deflation doesn’t seem to be an obvious threat either.  And we actually prefer a little inflation right now.

You see, normally inflation is viewed as a huge threat.  Nobody likes to see the prices of goods and services skyrocket.  Why? Because wages usually don’t increase at the same pace.  And that means the standard of living is going to decline for most people.

But inflation can be very positive for the economy… especially during a recession.  When the economy is struggling, a little inflation can be a good sign.  It can mean demand is picking up.  Plus, companies and governments need some inflation to grow their revenues.

And that’s not all…

A little inflation means deflation isn’t an immediate concern. Deflation is very bad for everybody.  Falling prices can lead to high unemployment, bankruptcies, and political instability.  Think “Great Depression”.  It’s definitely not the environment we want to be in.

Look, we’re in an unusual period.

There’s a mixed bag of opinions on what’s coming next.  Some economists think inflation is just around the corner.  Others are still concerned about deflation.

Here’s the key… the only opinion that matters is the Fed’s.

The Fed’s views determine where interest rates are set.  And of course, interest rates are one of the main drivers of economic activity.

So with the economy stagnating and CPI coming out as mostly flat, should we worry about inflation right now?

I think we should. Here’s why…

Recently released retail sales numbers show sales across the country are picking up.  It’s a small increase, but consumer spending is a huge component of the U.S. economy.  Even a small uptick in consumer spending means inflation isn’t too far behind.

And don’t forget “QE2” from the Fed.  If the Fed significantly increases the money supply as they’ve promised, many believe it will lead to inflation.

So when will inflation start to matter?  Probably sooner than you think.  I know I’ll be watching the economic data closely over the next few weeks.  Interest rates, gold, equities… they all could move significantly on news of inflation.  I recommend you keep a close eye on the data because the impact of inflation is too big to ignore.

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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