What Really Goes Into the Fed's Favorite Measure of Inflation?

25:35And so if the Fed is raising rates faster than deposit rates are moving, that's going to show up as more inflation. And then we saw relatively high inflation from this category in 2022, and it really moved the needle on core PCE even. And then on the other side of it, when SVB hit, you obviously started to see banks start to raise their deposit rates more aggressively, and the Fed slowed down on hikes. And so kind of weirdly, because of both of those factors, you've seen that part of BCE really ratchet down in the last six to nine months. And this is all very weird stuff where it's basically a function of, well, Fed hikes are kind of inflationary through this category, and then slowing down on Fed hikes and getting some deposit rate catch up ends up being the opposite.

26:20It's kind of very bizarro stuff. There's some other things that matter, but it just kind of goes to show you that there's a lot of silly parts of this core VC. I didn't say some parts court CPI, but it is, uh, people tend to think the stuff is all very fundamental and mechanical. And I just would caution that there's a lot of weird methodology and imputations that kind of go into various parts of that complex. This is an interesting wrinkle to my campaign to improve the transmission of monetary policy by making everyone switch to higher interest bank accounts. But, okay, I'm going to ask a slightly or very provocative question, but just on the question of how we measure shelter costs, can both of you choose, like, if you had to pick a preferred measure, would you be team CPI slash BLS or would you be team, you know, PCE and BEA?

27:12I would probably say

27:18this is tough actually now that I think about it on some level the BEA is using the BLS data and so the data itself about rent and owner's equivalent rent are coming from the BLS and the CPI and all of its perfections and imperfections I think the better question to ask is whether market rents or contracted rents what we're basically measuring in CPI what the BLS is measuring is contracted rents. So they tend to lag. They tend to lag. They also tend to be a little bit smoother, a little bit more autocorrelated, a little bit more obviously cyclical in a way that, let's say we had been using market rents this entire time, we probably have much lower inflation ratings now, where we probably see something close to 2 % on the Fed's key gauges.

28:03And yet we would have had very, very high inflation observed in 2021. Maybe that's actually the true version of what was going on. But you also get you there's a bit of a trade off between getting smooth and cyclical versus something very volatile and jumpy and maybe not as reliable in terms of how to set monetary policy if you think that operates with some lag, which and so you would have either like a super, super high inflation bulge in 2021 or something a little bit more smoothed out over 2021 to 2023. These debates kind of can cut up either way. And I'm not sure which is actually necessarily better, but it's better to just appreciate the fact that there's a lag.

28:41Yeah, I'm going to come back and I'm going to say CPI. They're very definitive. Yeah, the simple reason for that, I think in my mind at least, is the stuff that is quirky in the CPI, like we've talked about health insurance on the show before. The stuff that is quirky in the CPI, the PCE essentially just magnifies that even more by some of the items that are in that index, like the financial services furnished without payment index that Skana talked about. I think there's even more stuff in that index that is sort of conceptual and imputed. I mean, roughly 13 % of the entire core PCE is just these imputed prices that no one sees, which is why, by the way, we also have a market-based core PCE to get rid of that and just look at actual prices that people do pay and people do see.

29:31So the CPI does, of course, have some of that, but I think there's less of that influence in the CPI than in the PCE. And yes, we can talk about OER being heavier weight, but at the end of the day, that's in both indexes as well. So I would probably prefer the CPI over the PC.

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31:59Try Odoo for free at odoo.com. That's O-D-O-O dot com. Let's talk about more of these interesting categories. So one of the things that we saw, especially in the sort of, you know, the 2021, 2022, this sort of big shift in consumption patterns between goods and services. And we talked a lot about, okay, goods are doing this and services are doing that and goods prices through the roof, etc. But one of the things that you both pointed out over time, and I've heard you talk about this a fair amount, Skanda, is that this idea of drawing a bright line in many instances between a good and a service, particularly when it comes to measuring costs, is sort of impossible or fallacious in some way.

32:44And so auto insurance seems to be a big area in which we call it a service for measurement purposes, but it has connection to the goods aspect. Can you explain that a little bit further? Sure. I think the conventional wisdom, and the Fed has obviously done its job in trying to propagate this, which is to say that, okay, the goods side of the economy, that's supply chains, that's like maybe a commodity shortage, you're there. But services, services sounds like labor, services sounds like wages. Service prices are obviously a function of what people are who are working, how much are they paid, and then it's just some spread on that.

33:15So wage growth should be dictating services. There's like an okay guide for maybe understanding even housing costs. We think of like services as like some a restaurant worker or a masseuse or someone painting your house or something like that. And so it's very much like very linear to labor costs. Yes. And so you think of someone who's maybe cutting your hair, right? It's like that probably is more directly tied to one another, right? But at the same time, things like even like, say housing, which I think of housing and rent as actually being related to the labor market, but it's not the cost of like construction or maintenance that's really dictating the cost of rent.

33:49It's the marginal supply and demand for housing. And that's something that's not really driven by labor in a sort of proximate direct sense. But then we get to a lot of things like vehicle insurance, and we get to airfares. Those are areas where you can definitely point to specific things where goods and goods supply chains really matter. So jet fuel costs are very important because they're the most variable cost in like an airline's cost structure. Quite reliably, jet fuel costs feed into what airfares look like. So when jet fuel spiked in 2022, due to sort of the invasion of Ukraine. You saw obviously crack spreads blew out, oil prices blew out, and therefore jet fuel prices blew out.

34:30And that had a pretty reliable and predictable pass-through into airfares. And that even showed up in previous instances, like the 2008 oil price spike having a pass-through effect into airfares. In the case of vehicle insurance, right? And it's not just vehicle insurance. We can think about motor vehicle leasing, repair, maintenance, rental. These are all what I'd call value sensitive services. So the value of an automobile will shape the cost of being like that also affects the price of parts. Right. Because let's say automobiles are in shortage, then the value of repair goes up because of it.

35:04The value of spare parts goes up. And we've basically seen that. And that's obviously affected the cost structure for insurers. There are some other regulatory dynamics going on with respect to vehicle insurance. And that also has an implication for CPI that's different from PCE. but the connection between goods to services is itself like kind of important to appreciate. Yes, services tends to move more slowly with more of a lag, but it is kind of fundamentally moving with respect to a lot of these dislocated supply chain and commodity supply issues in ways that I think are in some ways just removed from the labor market itself.

35:38I think that is something the Fed has been kind of keen to say, well, the labor market must matter somewhere. So let me jam it into all these other services aside from housing. In practice, though, there's just a lot of stuff even in supply chains and commodity price swings that actually have a lot of relevance beyond what we strictly classify as a good and has a lot of impact on the services side of the economy and services that are consumed, but maybe actually pretty capital intensive or not necessarily tied to the direct price of labor. That reminds me, actually, can you talk a little bit about the timing of some of these pricing decisions.

36:15And what I mean by that is I remember talking to Omer about producer prices for mayonnaise. I guess this would have been over like two years ago. And there was an idea there that companies often revise their prices around quarter ends. There's also a more recent phenomenon that I think the Goldman Sachs analysts are calling the January effect, this idea that, well, in a new year, lots of people revisit how much they're charging and unveil all their new prices around the new year. But talk to us about the actual timing and mechanics of how prices get changed. So I will say that there is this so-called January effect, which the rest of us just call residual seasonality in the data.

36:58That's been something that's been prevalent in the start of the year price increase is something that's been prevalent in the CPI data, really for probably the last 20 years or so. And you tend to see it much, much more in goods. We're talking more about furniture, apparel, things of that nature, where contracts for delivery tend to get reset for the start of the year. And so what you'll typically find is that, yes, at the very start of January and February, you tend to see prices on an unadjusted basis increase by more than what you'll see them do over the balance of the rest of the year. And that's something that's been pretty well known in the CPI data.

37:38And the idea is that seasonal adjustments should be able to sort of offset that seasonal move every year. But of course, the problem is that, you know, those price increases aren't sort of a static thing. They tend to move around quite a lot. And so seasonals never quite are able to capture it in that first go. It's only sort of several years later when the seasonals are kind of redone on those particular years where that effect kind of compresses in January. But we saw it, you know, this year for sure, where we had some big moves. What was really interesting though, so typically residual seasonality, the way it works is that first quarter, the Q1 data is typically stronger than the rest of the year.

38:19Two thirds of that strength is in core goods. And only about a third of it is coming from the services categories, which makes a bit of sense when you think about, you know, delivery cost changing for shipping, goods items across the country and from overseas. That gets worked into new contracts at the start of the year for goods. What was really peculiar this year, though, is that goods really didn't do much, you know, core goods, even excluding autos. All the strength was really in the services categories. And that's what really kind of stood out this January was it wasn't traditional, you know, it wasn't your father's residual seasonality.

38:55This was something a little bit different because it was so heavily focused on the services side. And so that's something I think we just need to be careful of going forward is normally when you think about residual seasonality, you say, okay, you know, so January, February effect, once we get into the second quarter, it'll go away. And if it was in core goods again this January, I would have said, yes, that's probably the right take. But I would just say there's maybe a little bit more caution here needed because it wasn't in core goods. It was in core services. So I think that's just something we need to be a little bit careful of, you know, thinking about the data going forward.

39:25And something that may be an extension of Omer's point here, right? So in Omer's time about core services and CPI, this is exactly where thinking about the wedge is especially important. Because when you think about the particular prices that are of relevance for PCE, once you get outside of goods and housing, or in goods and rent and owner's equivalent rent specifically, there's a pretty big divergence between what you learn from CPI, especially in that kind of super core, core non-housing services. CPI is very different from core non-housing services PCE. And they're just like, we talked about imputed financial services as being one goofy example.

40:07But there are other examples, including vehicle insurance and airfares, where they're just measured in different ways. And so the residual seasonality that shows up in one part of a core service CPI segment doesn't necessarily have a neat, cognate... But how are they measured differently, those categories in the two indices. Which categories? Well, I think you said airfares and motor vehicle insurance are measured differently. So motor vehicle insurance, for example, is more directly... Insurance products in general and CPI is really about a function of payment and what's really the out-of-pocket cost to the consumer conceptually.

40:45So it's really tracking that in real time. And obviously right now you have a lot of state-by-state insurance companies are are pushing for regulators to allow them to charge higher premiums for auto assurance after sort of a cycle of, I think, a lack of profitability relative to the cost and expenses for an insurer. Whereas for insurance products in PCE, it's really about the value that it's trying to proxy or capture, right? So the value to the consumer is a function of not just what you pay, but also what third parties are paying and what you're getting back in terms of the expenses that have to be covered.

41:18So they do tell you different things there. So vehicle insurance in PCE has been much more benign. It comes from a PPI segment, whereas vehicle insurance in CPI has been very strong. And so that's like one part of the divergence. Then there's another one with airfares is actually a function of, I think America can really speak to this with high expertise here, but the CPI is tracking very specific routes and trying to track them systematically over time in terms of how much it costs to be able to fly from one place to another, different categories of seats on airplanes. But in PPI, it's meant to reflect sort of the revenue per passenger mile, and it tends to have a little more of an upward bias, actually relative to CPI.

41:59So PPI for airfares has generally run stronger than CPI, and especially so. So despite the wedge blowing out, it hasn't been a function of airfares as much as other categories. But I'll let Omer or expand further here. Well, I was just going to actually just quickly put some numbers on the auto insurance thing because yes, the methodologies are different, but to give you some sense of it, auto insurance and the CPI right now, year over year is running at about 21%. And the PC is running at about 8.7. Wow. So, you know, methodologies are different. They produce vastly different numbers and growth rates for these two indexes.

42:34So given their weightings, you're going to have just, you know, a very different influence of what is, ostensibly, it seems like on the surface, the same thing, auto insurance, but the different measurement is resulting in just vastly different growth rates, which means its impact on the core and core services overall is also just going to be hugely different. So that hopefully, you know, kind of gives some context around what the difference in methodology can mean for the growth rates around these particular items. On airfares, yeah, you know, it's kind of mentioned it's the CPI is basically very much just a weighted average of routes, you know, Chicago to LA, LA to Vegas, what have you, and is very much just capturing directly from the carrier's website, what it is that you're paying for that flight, and also the cost of the first check back.

43:22And the PPI is, you know, is also looking at these routes, but looking at the overall revenue per passenger mile, as kind of mentioned. So month to month, they can actually differ quite a bit over the longer term, the trends directionally, they tend to be in the same direction, but it can cause variability on a month-to-month basis where you could have the CPI, for example, up 3%, 4 % and the PPI actually down a couple of percentage points. So on a month-to-month basis, you do have to be aware of what these differences are because they can produce pretty different results and pretty different impacts on the relative course.

44:01Airfare is a really big one in terms of CPI just because it's so volatile in the CPI. And you'll typically hear right afterwards, well, core services, ex-housing CPI was really strong or really soft. And it's driven by airfares. And that just doesn't have the sort of bearing on that sort of super core PCE component, because that's coming from BPI. And you know that usually only a day or two later. I can't tell you over the years, the amount of time and money I've spent trying to get airfares right, and it's worth like less and 1 % of the core CPI. Because, you know, again, the volatility, it could be up 8%, down 8%.

44:35And so it can add or subtract, you know, five to 10 basis points each month from the core. And so getting that, you know, it's just one of these high volatility ones where, yes, it's not worth a lot, but the magnitude of the moves is so great that it just, it demands a lot of attention, you know, like hotel rates as well. Same thing. Gosh darn airlines and their dynamic pricing. So we mentioned earlier that we're recording this episode right before PCE. comes out. Can I put you both on the spot and ask you for PCE guesses? I am probably, I think, a little bit below some of the, so most of, I guess, the forecasters I would want to follow are right around 0.40.

45:14I'm a touch lower at 0.36. I think the difference is just assumptions about imputed prices that people are making. But on the super core PCE, I'm expecting a 0.5. So that is going to be, you know, pretty strong print, I think. Obviously, in the core CPI, we had about a 0.85. But yeah, I think it's going to be a relatively firm print, the PPI data was strong, the CPI data was strong. So at least for January, it looks like we're going to get a pretty robust move in the PC data. Yeah, this is actually coincidental, because I'm not sharing my work with Omer on these things. But we end up in the same place on both core PC being 0.36 % and C per core for myself 0.50%.

45:54But I also will note like for at least on the year over year reading, something to appreciate is there's also revisions. So while some people might have higher month over month readings, they may also reflect the fact that there are reasons for revisions to prior months. So for example, and it's something I think also Omer be here to talk about too, which is financial services prices, now not the imputed ones, but the ones that are more measurable, those prices also kind of factor into revisions. And those are why I suspect that we're probably going to see more shallow inflation progress. So if we kind of were around high 2.9%, low 3 % last month, that's actually going to bump up a bit.

46:32And at the same time, we're going to see 2.8 % for Core VC. Real quickly, I'm glad you said this is going to be my last question. Explain measured financial services. So when stocks go up, measures of inflation go up. Correct. To a first approximation, measured financial services are a lot of the portfolio management services that consumers are effectively consuming. And those, the way they're measured, tend to, in the aggregate, kind of proxy what the equity market's doing. How much so can vary a little bit over time, but the equity market does matter. So the equity market's been up a bunch over the last few months, and that has taken time to really show up in the PPI data.

47:10but it has and that PPI data kind of is relevant for sort of PCE purposes. Yeah, and in the PCE, that Portfolio Management Index is, you know, it added quite a bit to the January core PCE number. I think it's going to add something like eight basis points to that number alone. And that is mostly a reflection of how the equity market did in Q4. So up around, I think S &P was something like 12, 13 % higher. That pretty much goes into the returns that are reported to the BLS. So these equity returns from mutual funds and ETFs and private portfolio managers, they come back and say, hey, we did great in Q4.

47:51Here are our numbers. That gets built into the PPI data, which then flows into the PCE. And so the index is worth about 1.5%. But when you're up 5 % or so, roughly as it was last month, you're going to get a big pop in the core PCE. So that's likely what, you know, we already saw it in the PPI. That's what's going to feed into the PCE. So equities do matter quite a bit for that number. All right. Well, this episode comes out at 4 a.m. Eastern on the 29th. So people have four and a half hours to listen to it and then, you know, understand what's going to come out at 8.30 a.m. Eastern. Omer and Skanda, thank you so much for coming on.

48:28That was fascinating. I want to do more of these episodes where we actually learn about the data that we talk about all the time. But I appreciate you both for coming back on the Oblogs. Thank you. Thanks for having us.

48:51Tracy, I found that to be a really interesting conversation. I have to say, you know, the cranks will hate me for this. I have a lot of admiration for the public officials, the bureaucrats, the economists at the BLS and BEA who have to assemble all this stuff and figure out, like, you know, the different ways of measuring airline costs and portfolio management costs. It doesn't seem easy. I think that's a totally fair thing to say. The other thing I would say is like the people doing this, at least at the BLS, are really responsive to inquiries. And Omer would be able to talk about this and maybe we should have asked him.

49:30But if you send them a question and ask – I did this for that mayonnaise story – and ask them like, how are you calculating this particular line item? They will get back to you and they'll get on the phone with you and explain it for like 20 minutes. This is true. And actually listeners should know this. Wait, don't flood the BLS with calls. Don't flood the BLS. But when you see someone and you see something, they're like, oh, this is people like, oh, this is crazy. Look what they hid in this area. They're very transparent. And this is true. They'll call you can call them up and they'll say, this is what we this is how it works.

50:03So Tracy's making an excellent point. No one's going to take us up on that because people prefer to believe conspiracy theories. But if you see something that seems they will respond. If you see something, say something. If you see something, if you see a weird number, call them up and explain. they will explain how it came down. Well, the other thing that comes out of that conversation, and again, I thought both Skanda and Omer were incredibly clear in laying out the difference in methodology, but really the overarching theme is the amount of like subjectivity and value decisions being made when it comes to how to present this overall data.

50:38And you can get super granular on this and think about all these things that are sort of hidden in the background. But I I remember there's stuff like, you know, the weighting of certain items is different depending on where you are in the country. There's also qualitative adjustments. So, you know, your refrigerator, maybe the price is declining, but now it comes with Wi-Fi. And so you have to incorporate that qualitative judgment as well. Well, you know, in some of these things, you know, Omer made this point about I think in one of the insurance categories about how CPI and PC are different.

51:10So you could imagine, you know, let's say someone pays, I don't know,$100 a month for car insurance. And then the next month, you know, the next year, it goes up to$110. So that's a 10 % increase. But, you know, let's say that in that second year, you know, you're getting$107 back every month equivalently in repairs for your car. In the previous year, you were only getting$90. Well, maybe arguably your insurance just got cheaper because the amount you're getting back relative to the amount you're paying is so much higher. And so you can see immediately how something that's very important, insurance, huge parts of the economy, becomes incredibly difficult to measure when you're trying to gauge like, well, are you just trying to gauge how much you pay?

51:54Are you trying to gauge how much you paid relative to the value of the service you received, which is going to be, you know, change based on the value of your car and the difficulty of obtaining the replacement components? It's really tricky stuff. Well, I also like Skanda's point on this note about deposit betas and the impact on inflation. It's so wild. That blows my mind. I know. I feel like we should end this before we start talking about how gas prices going down is actually inflationary because people spend more. I thought you were going to say we should end this before I suggest that we should be paying our banks for checking services.

52:25Well, that too. But no, it really clicked because we had that episode with Stephen Kelly and I was like, well, what is the service of a bank? And he's like, the service of a bank is deposits and that's why you get a sub. You get that cheap rate because they're providing you a service. So there is this sort of intellectual logic behind, OK, you're getting 2 % rates for your checking account. Fed funds at 5%. Therefore, implicitly, you're paying 3 % for those checking services and all those other things. But yeah, these are tricky things to measure. But it is funny how mechanically, just like the Fed raising rates and increasing that gap between rates and deposit rates just sort of mechanically increases measured inflation.

53:05Joe, you're about one connection away from breaking out the yield bug hat again. I'm like that. What's that meme of the guy? I think it's always sunny in Philadelphia. That's where I am right now. Okay. Shall we leave it there? Let's leave it there. This has been another episode of the All Thoughts Podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Joe Weisenthal. You can follow me at The Stalwart. Follow our guests, Omer Sharif. He's at Fcast of the Month and Skanda Amarnath at Irving Swisher. Follow our producers, Carmen Rodriguez at Carmen Erman, Dashiell Bennett at Dashbot, and Kale Brooks at Kale Brooks.

53:42Thank you to our producer, Moses Andam. For more OddLots content, go to Bloomberg.com slash OddLots for transcripts, blog, and a newsletter. And you can chat with fellow listeners 24-7 in the Discord, discord.gg slash OddLots. And if you enjoy OddLots, if you like it when we discuss the methodology behind some of the big numbers that we talk about on a daily basis, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is connect to your Bloomberg account with Apple Podcasts.

54:19Thanks for listening.

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