“Inflation” is a buzz word nowadays. No matter where you turn, it’s hard to miss news stories about inflation.

Even if you never pay attention to the news or never go on the Internet, if you buy anything, you will notice the higher prices. Whether it’s at the pump, the supermarket, or anywhere else, there’s nowhere to hide if you are a consumer. The only question is how much more you are paying.

Clearly, in an inflationary period, prices for goods and services are rising. To catch up, you will need your income to go up too. If you are buying the exact same goods year after year, you can compare what you spent this year to what you spent last year, and the change percentage is the inflation rate for your basket of goods. But if you want to quantify just how much prices are up in the economy as a whole, it’s a much more difficult task because there are so many different goods and services available and spending habits change.

For a consumer, what immediately matters is what he/she is paying now. It doesn’t matter whether the official inflation rate is, say, 3%, 5%, or 8%. If John is paying 20% more for his beef today compared to last year, then 20% is what matters, even if the inflation rate is 5%.

The Need to Quantify Inflation

But governments, which set monetary and fiscal policies, need to quantity inflation. And it’s no simple task. Since a government can’t possibly measure every citizen’s spending trends with exact precision, it needs to come up with an approximation in the form of indices that represent what a typical consumer may purchase.

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Because these indices influence government policy, which in turn affects the economy and financial markets, it behooves investors to have at least a basic understanding of the difference among the most important indices. For example, in the U.S., inflation and unemployment are the two factors that most influence monetary policy, such as interest rates, which have a major impact on the stock market.

Today we will briefly highlight three such big U.S. indices.

Urban Consumers Basket of Goods and Services

The most commonly quoted measure of inflation is the Consumer Price Index (CPI), maintained by the U.S. Bureau of Labor Statistics (BLS), a unit of the Labor Department. This index is meant to be a representation of the spending by urban consumers for a weighted basket of goods and services. It assumes that a typical city dweller will consume a certain group of goods and services and how the cost of this consumption changes over time.

The CPI makes a very important assumption that consumers will substitute one good for another (e.g., chicken for pork) if the original good becomes too expensive to achieve a constant level of satisfaction. This understates inflation felt by consumers in real life because the calculation constantly replaces goods and services in the basket with cheaper substitutes. The government also makes certain assumptions that ignore real costs from the calculation. Due to the CPI’s shortcomings, policymakers usually don’t base decisions on this index.

Why use an inaccurate index? There is incentive for politicians to keep the measure of inflation low. It sounds good on political campaigns and it reduces entitlement payment increases linked to the cost of living.

Inflation from the Producers’ Perspective

The Producer Price Index (PPI) is another BLS index. It measures the changes in cost from the viewpoint of domestic producers. The PPI can give an indication of where inflation is heading. Producers may be able to absorb higher costs for a while, but sooner or later cost inflation will pass through to buyers in the form of higher prices. Thus, the PPI is seen as a leading economic indicator. A jump in the PPI portends inflation at the retail level.

The index consists of three sub-indices: crude goods, intermediate goods, and finished goods, providing a look at goods at different stages of production. Generally, an increase in crude goods cost (i.e., commodities inflation such as what’s happening now), means that intermediate goods costs will rise, and then finished goods.

What the Fed Most Cares About

The third index, the Personal Consumption Expenditures Price Index (PCEPI), is maintained by the U.S. Bureau of Economic Analysis, a unit in the Department of Commerce. This index is particularly important because it’s the Fed’s inflation gauge of choice. When the Fed talks about a long-term inflation target, it’s referring to changes in the PCEPI.

The index measures inflation based on information from households, corporations, and governments, along with gross domestic product. Unlike the CPI, which only surveys changes at the consumer level, the PCEPI also takes surveys directly from businesses, and thus gathers more complete information. The PCEPI also takes into consideration changes in consumer spending patterns in the short run.

From an investment perspective, the PCEPI is very important because it directly influences the Fed’s monetary decision. As we’ve seen, extremely loose monetary policy is a huge tailwind for the stock market. By contrast, Fed tightening is a headwind. Thus, while the CPI is the most widely reported inflation measure in the media, it is the PCEPI that has the most impact on central bank action.

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