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

Episode Date: February 29, 2024

The Federal Reserve has a goal of getting inflation down to 2%. But of course, there are a lot of different ways of measuring inflation. Many people know about the Consumer Price Index, and the various ways it can be sliced and diced. The Fed, however, focuses on a different index — Personal Consumption Expenditure — which differs from the CPI in a number of ways, both in terms of category weightings and methodological approaches. So why are there different measures of inflation? Why does the Fed prefer PCE? And how is PCE actually assembled? On this episode, we speak with Omair Sharif, founder and president of Inflation Insights, as well as Skanda Amarnath, executive director of Employ America. We explore these two different measures, the approaches for calculating them, and the weird quirks underneath the surface that makes them all so interesting and controversial.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But on Vanguard, at Vanguard, institutional quality isn't a tagline. It's a big line. It's a very big. It's a firm. It's a few. commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio.

That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Bloomberg Audio Studios. Podcasts, Radio, News. Oh, and welcome to another episode of the Odd Lots podcast. I'm Jill Weisandthel. And I'm Tracy Allaway. Tracy, you know, it's funny.

There's all just talk about, okay, when is the, when is inflation going to get back down to 2%? When is the Fed going to hit its goals? But when we talk about inflation, there's a million ways to measure that, or at least two or three big ones. Yeah, this is one of the things that I've really come to appreciate. over time. There are so many different flavors of inflation, so many different ways of measuring it. My understanding is that there's basically, if you're going to break it down, there's CPI, there's PCE, there's core and super core of each of those. And the way to do it is just choose whichever one of those confirms your priors and then focus on that. That's what I do. That's the secret.

That's what I do. Whether it's PCE, whether it's CPI, look for the one that's closest to 2%. And if neither are that close, then I lop out something. It's like, oh, if you exclude rent and use cars and food and food going out, then we're at 2%. So it's time to cut rates. That's basically by my approach, but I'm glad to hear that validating. I mean, that is the running joke, isn't it? If you exclude everything that you need to live, then inflation is coming down. But I think the important thing, the really important distinction is CPI versus PCE. CPI is probably the one that people have in their heads when they think about inflation. But PCE, of course, is the Fed's preferred measure and the thing that the central bank is actually focusing on. And I don't know why that is, actually.

Yeah. Like, I know this, that most of the time when people talk, what's inflation rate right now, they'll look at CPI or maybe core CPI. But then we're like, but you know, the Fed looks at PC. And I guess, and I believe that to be true, but I actually don't know what it is about PCE that the Fed prefers. I don't know. I know there's some different weights. related to rent, and there's some few things there that caused them to change trajectory from time to time. I think it's smooth some stuff, is that right? It's supposed to be less volatile. But one thing I do know, and I have to admit something here, and it's kind of embarrassing at this point in my career as a financial journalist, but CPI includes something called owner's equivalent rent, which is basically

a measure of the cost of home ownership. And it comes up all the time as like a key difference between CPI and PCE. And I, for the world, do not understand what, well, I kind of get what it's supposed to be, but I don't get how it's measured at all. Well, you know what I've been thinking, generally, I think it would be good to do more episodes about how do we actually get the data that we get? Like, how do they do the jobs report survey? I actually don't really know much about that.

How do they do all these different surveys? All the smartest people we talk to tend to know this stuff really well. Anyway, this episode that we're recording right now, when you're listening to it, it happens to be PCE Day, the day that the Fed's preferred inflation measure comes out. And so we should understand what's in the Fed's preferred inflation measure and how it differs from other measures of inflation. I am really into this topic. I feel like this is going to be an episode that I like bookmark the transcript of and then go back and look at it over and over again. So I'm looking forward to it. Well, I am excited to say we do literally have the.

two perfect guests to talk about this, two people who really have a deep understanding and appreciation for how these numbers that appear on the screen. PCE for me is just a number that appears at 8.30am on my Bloomberg terminal, but the reality is there are all these surveys and calculations and then tabulations. And so there's a lot of hard work that goes into producing this number. So we're going to be talking to two people that have a deep understanding and appreciation for what goes in from a real bottoms up of how these numbers appear on our screens. We're going to be speaking to multiple-time guests, both of them,

Omer Shereef. He is the founder and president of Inflation Insights, as well as Skonda Amernath, executive director at Employ America. So Amir and Skanda, thank you both for coming back on the show. Thanks for having us. Thanks. Omer, you know, why do we start with you? Like, why do you answer the sort of basic question for us of what is the difference

between PC and CPI? Why do we even have two separate measures of this? Yeah, I think the simplest way to think about it is just that they're intended to measure somewhat different things. So they're designed to sort of do different things. The PCE is a much broader index. It captures essentially more of the economy, if you will, than what the CPI does. The CPI focuses a bit more on consumers' out-of-pocket expenditures, whereas the PCE covers not just that, but also what is sort of paid on your behalf by third parties or the government. And a good way to think

about this is healthcare. In the CPI, largely it's measured as, you know, your out-of-pocket payment, let's say for your co-pay if you go to visit the doctor. And there are some other additional measurements there as well. But in the PCE, it includes things like, you know, Medicaid, which is paid for by, through taxes, by the government. That's out of the scope of the CPI. So scope is really kind of the thing that differentiates these two indexes, because one has a certain scope, really consumers out-of-pocket payments, which is a CPI, and the other has just a much broader scope, and it's really able to capture more of what's happening in the economy and more of the inflation you see through the broader economy. And that's probably, I think, why you hear the Fed officials

say that, you know, their preferences for the PCE versus the CPI. Can you talk a little bit more about that? So how did it come to be that, that's the Fed officials, the Fed is focused more on PCE? Going back in history, was there like an announcement or a trigger for them to focus on that measure versus something like CPI? Yeah, I don't know that there's necessarily in a historical basis for it. I think it's just more that the PCE is more representative of the broader economy. You know, it just captures more of what the types of inflation that people tend to see across the economy, but it also captures some of the inflation that, you know, businesses are seeing as well across the economy.

If you don't want me jumping out, there actually is a history to this. It's actually... Oh, great. Why don't you take that one? Yeah. So the Fed, for the longest time, actually did sort of focus more on CPI.

They never had like a formal inflation target until 2012. But if you ask the Fed how they're tracking inflationary pressures, they'd probably point to CPI first until the year 2000. And so around that time, especially Greenspan, was focused on, so the notion of quality change and how substitution bias might be at work, where the composition of what consumers can see, changes, but CPI is conceptually more of a fixed basket relative to PCE, which is trying to dynamically change the weighting on the price index to match what people are consuming and put a little bit

more emphasis on how consumer spending patterns change. And so around 2000, the shift was from CPI to PCE within the Fed. The Fed didn't really say what kind of target was going to be the placed on it. I think it was implicitly assumed to be around one to two, one to two and a half percent, sort of where core inflation was. But actually, there was a very big difference in terms of whether you choose CPI or PCE, there's obviously just an inherent bias in which CPI readings tend to be a little bit higher than PCE. And so that itself kind of changes sort of if you thought 2% with some magic number.

It actually means different things if it's tracked in terms of CPI or PCE. What's happening, first of all, that's really interesting, and I didn't know that history. What's happening right now just to get up to speed? We're going to dive into the guts of some of these, but right now there is a gap between PC and the CPI or the course. What are we seeing in the trajectory of this sort of, I guess you call it the wedge, the jaws between these two lines? So typically the wedge between core CPI and core PCE to a first approximation, especially

pre-pandemic, you would have said it was roughly 30 to 50 basis points in the year-over-year readings. So 0.3 to 0.5%. If you know what core CPI is, you should be able to know what core PCE is. With a CPI being heard. Right now. With CPR being higher. Correct. Okay. Okay. And yeah, if you look right now, core CPI, year over year is something like 3.9% on a year over year basis. And CorePCE is going to track something on 2.9%, maybe 2.8, somewhere around there. Those readings are quite different, right? That's about 100 basis point spread. When the typical spread was 0.3 to 0.5%. And yeah, there's obviously a lot of variety of factors that have led to that. I'll kind of let Omer kind of jump in to sort of how, if you were trying to explain this on a,

sort of the first major reason kind of that sticks out to him. Sure. Yeah. So, you know, I think everyone normally focuses on the weights, right? But I think Joe, you mentioned that earlier. And so they tend to focus on things like shelter inflation, right? I know we are. And the weight of that in the PCE is only about, you know, 15, 16 percent, but of course, in the CPI, it's about 43%. And so people tend to focus on that difference and say, well, you know, that tends to cause a big part of the wedge. And that's true in a very sort of static sense. And that, what I mean by that is that over a short-term horizon, let's say, you know, six months, seven months, eight months, those weights are just not going to change materially, right? That difference is just going to be

roughly about the same over a short-term time period. And then the year-over-year rates, obviously for OER, don't move too dramatically either. So whatever that wedge is coming from shelter inflation in one month will be roughly the same, you know, wedge in six months. What's been going on more recently, really the last six months, is that, you know, Scott now talked about the spread historically being 30 to 50. We had gotten down to about 45 bibs in July. So we were very close to kind of a historical norm between PC and CPI. In the last six months, it's blown back out to 1%. And that's largely because the PCE has been slowing much, much faster than the CPI.

And that's typically something, you know, people generally focus on the CPI as being the one that kind of causes the movements. But right now what we're seeing is actually, it's the core PCE that is just slowing much, much faster than the core CPI. And that's blown the spread back out from about 45 bibs or so. in July to about the one percentage point. And there's more nuanced, you know, this isn't really about shelter. This is about some stuff happening in medical care. And really much more than that, it's really about the core services part of the story. And those are very, very different animals in the PCE versus the CPI. They're just not constructed the same in terms of the core services. And so that's really what we're seeing is core services is slowing really fast in the PCE.

And in fact, it's kind of gone up a little bit in the CPI. And just for your listeners to kind of get a sense that CPI is source data, which is to say it actually is a measure of they're doing the direct measurement, the direct surveys of prices. Better to think about PCE as a composite of different sources, including CPI, but not limited to just CPI. We also learn a lot about PCE from PPI input data, not the PPI aggregates themselves, but specific inputs. As Omer kind of alluded to in healthcare, there are inputs there from PPI that matter for PCE. And then there are things that exist outside of CPI and DPI that also matter. And it's that PPI and that other stuff that really feeds into core PC in a pretty meaningful sense

and has driven more of this short-run divergence, even beyond what you might explain from kind of changes and weights, rent, owner's equivalent, rent. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, Go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio.

All investing in subject to risk Vanguard Marketing Corporation distributor. Eating well shouldn't be complicated, but somehow it turns into recipes, prep, cleanup, and half your Sunday gone. Factors solves all that. These are fresh, ready-to-eat meals designed by dietitians, delivered to your door and ready in just minutes. No prep, no cleanup, no excuses. And it's not just about convenience. You're getting real food, balanced nutrition, and zero artificial stuff. Meals that help you stay on track for all of your goals without the grind of doing it all yourself.

Grilled chicken, roasted veggies, steak plates, postables. They taste like something you get in a restaurant, but they come out of your microwave in two minutes flat. If time costs or effort have been holding you back from eating better, Factor just took those off the table. Right now, get 11 meals, free shipping, and free sides for life. Hurry, this offer won't last long. Go to factormeals.ca and use code fit. That's 11 meals, free shipping and free size for life, but only with the code fit at factormeals. Facture, Canada's number one ready-to-eat meal delivery service.

So I definitely want to dig into what's driving these various inflation numbers at the moment even more. But before we do, I have a sort of existential question, which is I'm always kind of amazed at how much mental energy we expend on the question of, what prices are doing at the moment. And it seems like one of those things that, like, all right, there's observable prices for everything. So, like, why is it so difficult? And obviously, the weightings come into play here and what you choose to focus on, et cetera, et cetera. But doesn't matter if PCE is different to CPI? I mean, if we understand the difference in methodology, why should we care about this divergence? I guess I think it matters to the extent that you are trying to anticipate.

let's say a CPI index if you're someone who's, let's say, investing in inflation-linked financial products, or if you're somebody who's trying to focus on how the Fed is supposed to react when the Fed has kind of laid out an inflation target that's anchored to 2% on PCE and proxied by core PCE over time. You'll get slightly different answers. That's kind of the technical sort of markets-oriented answer. The bigger thing is actually, I think if you ask maybe some economists, they'll probably tell you, well, if you just like CPI, PCE, you EPA, what all doesn't really matter. It should average out. There is some underlying price level that these are all just like imperfect approximations of the price level. But in practice,

you get some pretty big divergences, especially in real time, because of choices in weights, choices in methodology, choices in what scope of goods and services you're going to put more emphasis on or less emphasis on. And you'll get different answers. And this is kind of how like that cottage industry of different private sector measures. of inflation or trueflation or whatever it is, shadow stats, all various spectrum of crankery to less crank measures of inflation. But I think that that's kind of the byproduct of the fact that all these choices do matter, right? And it's like there is some level of faith to saying there's some underlying true inflation

and that's actually here and it's not there. It just really depends on the choices you make. I would just add two other things quickly. One is just simply that I think we care about the CPI for two reasons also relative to the PCE. One is that, you know, simply put, it comes out first and it shapes expectations for where inflation's going. So, you know, we get that number typically by the 12th, 13th of the month, whereas PC is the end of the month. So I think for a couple of weeks, people are digesting, you know, what is the Fed going to do based off of this inflation number? Even if we know their preference really is for the PCE, it just really starts to shape expectations very early on before we get the PCE.

And I think the second thing is that it's tied to real life in the sense that, you know, all the Cola adjustments made in Social Security, for example, are derived from the CPI. A lot of rent contracts are based on the CPI. So it does affect consumers in a variety of ways. And so I think that's why there's also still, you know, relative importance in terms of thinking about what the CPI is doing, in addition to what's gone to mention, which is that a lot of the PCE is built off of what the CPI is doing anyway. I want to get into, and we're going to get into the sort of like deep methodological questions and where these numbers actually come from, et cetera. But before we get into sort of complicated methodological questions, I want to ask a sort of simple

methodological question, which is like, how does the government say in the CPI track the price of a tomato? Or something, I don't know, maybe I don't know if tomatoes are a category, but something like that. Let's start with something simple, because I get why measuring insurance is super complicated, measuring various things like that really difficult. But let's take something simple. Every month the government wants to know, like, how much tomatoes and apples and pairs

cost. What is the basic process of collecting that information? Well, so there's the consumer expenditure survey conducted now, well, now every year, it used to be every two years. Basically, we're, you know, asking people to track their spending and what they're spending on and how much they're spending on these items. And there's, thousands of these surveys conducted annually. And so from those surveys, we're collecting data on what exactly, not just what, you know, kind of Apple, or whether or not they're purchasing apples, but what specific kinds of apples they're purchasing. And so based on all of this collected information, you are then figuring out exactly what you want to price and what the share

of spending is for each item in the basket. So, you know, Fuji apples versus Granny Smith apples, whatever it may be. And these are done at, you know, the metro level. So what's, the diary might be a little bit different, let's say, in Chicago versus, you know, Miami. M.E versus New York in terms of some of these granular items. So ultimately, it's a consumer expenditure survey that's sort of dictating everything from what it is that you want to collect prices for, where you want to collect those prices as well, because you're also figuring out where it is that people are shopping. And then, you know, how much weight to put on an item within the basket. So apples within the, you know, food at home grocery store index, use cars within the

transportation index and so on. So that really dictates everything in terms of the CPI and how it's sort of being constructed and what's being picked to be priced. Maybe this is a good point to talk a little bit about the deterioration in some of the survey responses that people have been discussing recently. So the idea that a lot of this is based on the proportion of survey respondents who actually get back to you and say this is how much we're spending on Fuji apples per month or whatever. And that percentage seems to be declining over time. I think I've written about this before, but I don't have the numbers in front of me. But it seems like that could be a pretty big deal for the accuracy of some of these figures or maybe just have some sort of

influence on them. Yeah, I mean, I think it seems to be an issue of because so many of these surveys are conducted over the phone, not everything in CPI is that way. Yeah, no one answers their phone anymore. If someone calls me, I don't pick up. I mean, this is the same problem with election polling, right, where we have a lot of non-response going up, and you don't know if that skews a certain way. And if you're kind of calling particular businesses, I don't, it's not, there's a more structured process there relative to say, election polling. But there is still an issue, I think, of a non-response that kind of permeates a lot of data. This is not just about inflation data now.

It's obviously like labor market data has the same problem where response rates are going down. It's taking more calls to be able to kind of fill out the survey. Relative to other data points, I'm not sure inflation data is actually as vulnerable, but it is still, this is a structural trend that, look, the data is only as good as you measure it, right? So this is actually going to be an ongoing challenge for the BLS, I suspect. So let's talk about some of these idiosyncrasies, particularly within core PCE, because there are some things where you can just go to the grocery store. you can go to Whole Foods and you can go to Trigger Joe's and you can go to Associated and

Wegmans and look at the price of Fuji apples or Red Delicious or God forbid Red Delicious. Hopefully those are getting a smaller and smaller weight in the basket because they're the worst apple. But then there are other things where you cannot do that. There is not just a price tag and things have to be imputed in some way. And so you have to sort of derive a no price for things where there is just not a public price. let's talk about some of these imputations and where they get weird, because I think this is where it gets like really interesting. Like, you know, when it comes to like we pay, people pay financial services.

They pay for a financial advisor, et cetera. I don't know that there's like a simple price tag that that can be established. Talk about some of these more interesting or complicated or ethereal categories. Yeah. There are a set of transactions, especially now as you get into PCE, where we have no real transaction. are observing, right? Probably the more common one would be sort of your owner's equivalent rent is very commonly cited because that is effectively trying to approximate, effectively the cost of rent for someone who owns

their house. And that is something that is not really a transaction there, but the BLS and the B.EA, B.A, obviously, compiling CorePCE, they are basically using rent data to do that. So from the CPI Housing Survey comes to rent data. That rent data is also then used for estimating owner's equivalent. rent. There's no transaction behind it, right? But it is basically saying we're going to assume this price represents what owner's equivalent of that looks like. It gets trickier when you get into some other things in PCE, though, relative CPI, something like imputed financial services,

where there's no transaction taking place. It's specifically the value you, you, the consumer, derive from your financial institution, your bank, when you are getting all these various services, free checking, all sorts of other things, you're getting some value from whatever it is. Chase, Bank of America. I'm just going to examine. examples. You're getting some services, and yet you're also not being charged necessarily, you're not getting sort of the deposit rate that reflects what, like, the bank itself earns. Well, you're paying for it in that spread between the bank deposit and Fed funds. Precisely. That spread is a big part of how, of the implicit price. And so the BIA is

simultaneously trying to measure what's that volume of value that the consumer is deriving, and also the way of, like, proxying, what's the price associated with that? that value. And these are two things that are basically like dark arts, right? Like, it's kind of a, not, not like something that follows an obvious and verifiable method for being able to say, this is how much value you're deriving. There's just a lot of rough approximations. It's probably the funniest bit of core VC for my money, because it is a function of two factors, which is the value you can think of as that spread between deposit rates and call it benchmark money market rates. And so if the Fed is raising rates faster than deposit rates are moving, that's

going to show up as more inflation. And so, 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 VCE 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.

It's kind of very bizarre of 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'd even say some part core CPI, but it is people tend to think this stuff is all very, very 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 a 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 B-EA? I would probably say, this is tough, actually, now that I think about it. I mean, on some level, the B-E-A 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, Housing Survey, and all of its perfections and imperfections. I think the better question to ask is sort of like whether market rents or contracted

rents, what we were basically measuring in CPI, what the BLS is measuring is a, 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, whether we probably see something close

to 2% on the Fed's key gauges. And 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 more, 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 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. Yeah, I'm going to come back and I'm going to say CPI. And the CPU is just, 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 for that payment index that, you know, Skana talked about. I think there's even more stuff in that index that is sort of, you know, 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. So the CPI does, of course, have some of that, but I think there's less of that influence in the CPI than in the PC. And yes, we can talk about OER being heavier weight, but at the end of the day, it is that's in both indexes as well. So I would probably prefer the CPI over the PC. Eating well shouldn't be complicated,

but somehow it turns into recipes, prep, cleanup, and half your Sunday gone. Factor solves all that. These are fresh, ready-to-eat meals, designed by dieticians, delivered to your door, and ready in just minutes. No prep, no cleanup, no excuses. And it's not just about convenience. You're getting real food, balanced nutrition, and zero artificial stuff. Meals that help you stay on track for all of your goals without the grind of doing it all yourself. Grilled chicken, roasted veggies, steak plates, postables. They taste

like something you get in a restaurant, but they come out of your microwave in two minutes flat. If time, cost, or effort have been holding you back from eating better, Factor just took those off the table. Right now get 11 meals, free shipping and free sides for life. Hurry, this offer won't last long. Go to FactorMeals.ca and use code fit. That's 11 meals, free shipping and free sides for life, but only with the code fit at factormeals.ca. Factor, Canada's number one ready-to-eat meal delivery service. You have the desire to help, to make a real difference? The College, LaCity, you offer the program Dependance and Scenti Mental. Acquire the competences essential for to accompany and

to support the people confronted to the health mental and to dependance. Construise a career enriching to service

of the community francophone of all the country. Don't know the soin' quality in French, it's possible with

the city. Visit the Collage LaCeat right now. An initiative of the Consortium

National of Formation in health, supported by Santa Canada. 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, in 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, et cetera. But one of the things that you both pointed out over time, and I've heard you talk about this, a fair amount, Scanda, 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. And 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 year or there. But services, services sounds like labor. Services sounds like wages. Service prices are obviously a function of what people who are working, how much are they paid, and then it's just some spread on that. So wage growth should be dictating services.

There's like an okay guide for maybe understanding even housing costs, ironically. We think of like services as like 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? Yeah. That probably is more directly tied to one another, right?

But at the same time, 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. It'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 good 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 the crack spreads blew out, oil prices blew out, and therefore jet fuel prices blew out. And that had a pretty reliable and predictable pass-through into airfares. They 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 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. The value of spare parts goes up. I mean, basically seeing 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 versus 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.

I 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?

And 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 called residual seasonality in the data. That's been something that's been prevalent in, you know,

the start of the year price increase is something that's been prevalent in the CPI data, really for probably last 20 years or so. And you tend to see it much, much more in goods. We're talking more about, you know, 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 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. And the idea is the 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 it's, 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. Two-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 a traditional It wasn't your father's residual seasonality. This 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, it's a January for every 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. And something that may be an extension of Omer's point here, right? So in Omer's time of course, 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 goods called 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. But 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. How are they measured differently those categories in the two indices? Which categories? Well, you said, I think you said airfares and motor vehicle insurance are measured differently. So motor vehicle insurance, for example, is more directly taught. Insurance products in general in CPI is really about a function of payment and what's really the out-of-pocket cost to the consumer conceptually.

So it's really tracking that in real time. And obviously right now you have a lot of state-by-state insurance companies are pushing for regulators to allow them to charge higher premiums for auto insurance after sort of a cycle of, I think, a lack of profitability relative to the cost and expenses for insurer. Whereas for insurance products in PCE, it's really about the value that is trying to proxy or capture, right? So the value to the consumer is a function of not just what you pay, but also a third-party. are paying and what you're getting back in terms of the expenses that have to be covered. So 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 Amer 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 costs to be able to fly from one place and other 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. So PPI and 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 America expand further. 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 in 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. So given their weightings, you're going to have just, you know, a very different influence of what is.

sensibly, 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 got to mention it's, the CPI is basically very much just a weighted average of routes, you know, Chicago to L.A., 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 checkback.

And the PPI is, you know, is also looking at these routes, but looking at the overall revenue per passenger mile is going to mention. 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, you know, variability on a month-to-month basis where you could have the CPI, for example, up three, four percent, and the PPI actually down a couple of percentage points. So on a month-to-month basis, you do have to be sort of be aware of what these differences are because they can produce, you know, pretty different results and pretty different impacts on the relative course. Yeah, I mean, Airfare is a really big one in from the CPI just because it's so volatile in the CPI. and you'll typically hear right afterwards,

well, core services X 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 less than 1% of the core CPI. Because, you know, again, the volatility could be up 8%, down 8%,

And so it can add or subtract, you know, five to ten 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 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 or right around 0.40. I'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 PCE being 0.36% and supercore for myself, 0.50%. But I also will note, like, for at least on the year-over-year reading, something to be appreciate is there's also revision. 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 B 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. And real quickly, at the same time, we're going to see 2.8% for CoreVC. 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 out. Correct. To a first approximation, measured financial services are a lot of the portfolio

management services that consumers are effectively consuming. And 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, but 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 SMP was something like 12, 13 percent, higher. That pretty much goes into, you know, the returns that are reported to the BLS. So these equity returns from, you know, mutual funds and ETFs and private portfolio managers, they come back and say, hey, we did great in Q4. Here are numbers. That gets built into the PPI data, which then flows into the PCE. And so, So, you know, 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 and 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. And Omer and Skanda, thank you so much for coming on. That 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 appreciate you both for coming back on Oblons. Thank you. Thanks having us.

Tracy, 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 BE, who have to, B.A, who have to do like a 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. But 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. That if you see- Wait, don't flood the BLS with calls just to test this theory. But when you see someone and you see something, they're like, oh, this is, people like, 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 saw. This is how it works. So Tracy is 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 seem, 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 to. 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. And you can get super granular on this and think about all these things that are sort of hidden in the background. But 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, and Omer made this point about, I think in one of the insurance categories about how CPI and PC are different. So 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? Or are 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 Scanda'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're going to say we should end this before I suggest that we should be paying our banks for checking service. But no, it really could because, you know, 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. that's why you get a sub, you get that cheap rates because they're providing your service. So there is this sort of intellectual logic behind, okay, you're getting 2% rates for your checking account, Fed funds at 5%. Therefore implicitly, you're paying, you know, 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. Joe, 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 Wisenthal. You could follow me at the stalwart. Follow our guests, So Omer Sharif, he's at F-Cast of the month, and Skonda Amernath at Irving Swisher.

Follow our producers, Carmen Rodriguez at Carmen Armin, Dashal Bennett at Dashbot, and Kail Brooks at Kail Brooks. Thank you to our producer, Moses Ondom. 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.g. 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 your Bloomberg account with Apple Podcasts. Thanks for listening. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gura. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Ruffini. We'll bring you the latest headlines, in-depth analysis, and big interviews. All the stories that hit home on your days off. And I'm Lisa Mateo. Watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations about business, lifestyle, people, and culture.

On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world. That on Sundays, we speak with journalists, columnists, and key politics. political figures to prepare you for the week ahead. Join us as soon as you wake up and bring us with you wherever your weekend plans take you. Watch us on Bloomberg Television. Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern.

Make us part of your weekend routine on Bloomberg Television, radio, and wherever you get your podcasts. What separates good leaders from transformational ones? I'm Jessica Chen, and in season two of Leading By Example, we'll sit down with executives like Grace Chen of Bertie Gray to find out. It's important to understand where you spike, but also really acknowledge where you don't and find people who can fill those gaps. Listen to Leading By Example, executives making an impact on the IHeart Radio app, Apple Podcast, or wherever you get your podcasts.