Provided by Joseph V. Curatolo
The Federal Open Market Committee (FOMC) adjusts interest rates to help keep inflation near a 2 percent target. The FOMC’s preferred measure of inflation is the Price Index for Personal Consumption Expenditures (PCE), primarily because it covers a broad range of prices and picks up shifts in consumer behavior. The Fed also focuses on core inflation measures, which strip out volatile food and energy categories that are less likely to respond to monetary policy.
The typical American might be more familiar with the Consumer Price Index (CPI), which was the Fed’s favorite inflation gauge until 2012. The Consumer Price Index for All Urban Consumers (CPI-U) is used to determine cost-of-living adjustments for federal income taxes and Social Security.
The CPI only measures the prices that consumers actually pay for a fixed basket of goods, whereas the PCE tracks the prices of everything that is consumed, regardless of who pays. For example, the CPI includes a patient’s out-of-pocket costs for a doctor’s visit, while the PCE considers the total charge billed to insurance companies, the government and the patient.
The PCE methodology uses current and past expenditures to adjust category weights, capturing consumers’ tendency to substitute less expensive goods for more expensive items. The weighting of CPI categories is only adjusted every two years, so the index does not respond quickly to changes in consumer spending habits, but it provides a good comparison of prices over time.
According to the CPI, inflation rose 2.1 percent in 2016 — right in line with the 20-year average of 2.13 percent. This level of inflation may not be a big strain on the family budget, but even moderate inflation can have a negative impact on the purchasing power of fixed-income investments. For example, a hypothetical investment earning 5 percent annually would have a “real return” of only 3 percent during a period of 2 percent annual inflation.
Of course, if inflation picks up speed, it could become a more pressing concern for consumers and investors.
Joseph V. Curatolo is president of Georgetown Capital Group, 5350 Main St., Williamsville (phone: 633-9800, toll-free 1 (800) 648-8091, fax 633-9789, www.georgetowncapital.com).
Insurance services offered by Georgetown Capital Group, which is independent of Royal Alliance Associates, Inc., with separate ownership, and is not registered as a broker-dealer or investment advisor.
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