Macroeconomic & Geopolitical

How to Calculate the Most Important Number You Need to Know

January 2023 – 3 min read

For better or worse, the path of this year’s U.S. Consumer Price Index will determine the level of markets.

If there's one number that today's investors wish they knew, it’s the U.S. Consumer Price Index (CPI) this December. If it prints much higher than current expectations near 3% year-on-year, markets will presumably suffer because the U.S. Federal Reserve will need to raise rates higher for longer. If it turns out much below current expectations, it likely means rates have been too high and the economy risks teetering on the brink of a sharp downturn.

Breaking down the math behind the market’s inflation target Suggests the path ahead looks much harder than the path behind. Annual price growth will almost certainly fall from current levels as the effects of last year’s spikes fade but getting from last June’s 9% peak to the current 6.5% reading looks much easier than reaching the market’s expected number at year-end.

First, a word about this number that we call ‘inflation’. Of course, there are dozens of official ways to measure the pressures of rising prices in an economy, but none is barely more than a rough guess at the countless swirling price pressures that constantly distort all economic activity. The U.S. CPI, which gets so much attention, relies on a survey of 94,000 prices for commodities and services and another 8,000 rental units. The Bureau of Labor then makes heroic assumptions about things like the rent a homeowner might pay to live in the home they actually own and dozens of other seasonal and statistical adjustments.

In actual fact, a farmer’s inflation will be different from a doctor’s because they spend money on different things. Indeed, an Iowa farmer’s will differ from a California farmer’s. The Fed’s preferred measure of inflation, the Personal Consumption Expenditure Index (PCE), attempts to adjust for different spending patterns as prices shift, but this too is an imperfect measure. The latest PCE reading, by the way, came in at 5.0% on Friday, exactly in line with expectations.

Even if they are accurately recorded and seasonally adjusted, the prices themselves depend heavily on ineffable measures of consumer expectations. The more we talk about inflation, the more likely we will get inflation.

It’s not that there are much better ways to measure this complex and shifting phenomenon, but it’s worth remembering the uncertainty built into these numbers given the certainty of the market’s reaction to any deviation from expectations. 

Looking to December though, the overwhelming consensus feels right that inflation numbers are heading lower. The post-pandemic disruptions have past. Supply chains have normalized, extraordinary government transfers have ended and the pent-up consumption demand is playing itself out. The energy shock from Russia's invasion of Ukraine has also largely been absorbed as Europe has secured alternative sources of gas and oil.

When we peek at what lies beneath the headline numbers, there's little mystery as to why inflation has been falling. ‘Energy’ and ‘Used Cars and Trucks’, which together represent about 11% of the total basket, have been posting prices that are actually lower than a year ago, which has been very helpful in slowing the overall momentum of inflation.

Other stuff, which falls into a category called ‘Core Goods Less Used Cars and Trucks’ represents another 17% of the basket and actually posted brief month-on-month declines in September and October. We may get further falls this spring as households spend down their excess savings, but the risks remain that people will keep buying ‘other stuff’ if the labor market holds out.

‘Food’ which makes up 13% of the calculation, may not offer much relief either. Beyond the well-advertised calamity with egg prices, the U.S. Department of Agriculture isn’t expecting much more than a slight reduction in food inflation, from 9.9% last year to 7.1% on a combination of pressures from meat, dairy and sugar prices.

The two largest remaining elements in the basket present the biggest uncertainties: ‘Shelter’ at about 33% and ‘Core Services Less Shelter’ at 28%.

Housing starts and building permits are down roughly 20% and 30% respectively since a year ago as mortgage rates have risen, but don’t expect that to translate into significantly lower prices. Housing remains in short structural supply, which will keep a floor on how far any prices might fall.

Larger uncertainty hovers above the ‘Services’ component which depends heavily on people who like to be paid. Hourly wage growth has been slowing, which has been helpful, but the U.S. seems to be structurally short of workers the way it is structurally short of housing. The labor participation rate remains below pre-pandemic levels and both job openings and quit rates still look high.

For prices to materially undershoot current expectations would probably require a sharp deterioration in current conditions which would throw a lot of people out of work, and trigger falling prices for shelter and flat wages. That would be an ugly version of the recession everyone has been talking about.

More likely, the U.S. CPI will continue on a bumpy path lower, which means Fed won’t need to raise rates much more. But it also means, there may not be many rate cuts ahead if the year’s most important statistic comes in above current expectations.


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