There’s understandably a great deal of confusion on the subject of inflation and some of it’s measurements, CPI (Consumer Price Index) and core CPI. I think we all know inflation when feel the pinch of it on our wallets. Houses prices have gone up. As have food and gas prices. Yet those prices are not considered a part of core CPI. Funny considering food, shelter, and transportation are the core expenditures for most households.

What we typically think of as inflation is not the same thing that worries the Federal Reserve who is given the mandate to control inflation and keep economic growth chugging along. Inflation as thought of by the Federal Reserve is almost purely a monetary issue. The federal reserve is worried about the inflation caused by too many dollars chasing to few goods and services, and not worried about too few goods and services chasing too many dollars - if that makes sense. So for example if the economy were humming along great, and people and businesses are able to borrow money easily and cheaply this can lead to excess inflation. Easy credit allows more “money” to flow through the economy, and when times are good it leads businesses and people to potentially bid up prices too much as they compete for goods and services.

The Core CPI doesn’t include food and energy products even though for many families these are core expenditures. Food and Energy prices are generally determined more by supply than demand, and the supply of those products are volatile and subject to many external factors that are not inherent to the economy, weather being the most notable. The Federal Reserve tends to look at only the Core CPI values when making monetary decisions. The Fed effectively controls the money supply in the U.S. It has certain tools, most notably it’s ability to set the discount rate (the rate it allows banks to borrow from it) to control the money supply. The other tools are: Open Market activity (i.e selling Government Bonds and therefore creating new “money”), and determining the reserve requirement (the amount that Banks needs to hold against deposits that cannot be lent out).

The other big problem with inflation as measured by CPI and and most measure of inflation is that the index relies on a basket of goods and services. While the government takes a scientific approach to this problem, inherently this is a bit of subjective problem. Should the basket of goods be the same as the basket of good from 1880? I think that’s where many including myself unduly blame the CPI for being understated measure of inflation. The CPI certainly does have problems, but it’s inherently difficult to capture the lifestyle creep of the last century that is pervasive in American society. We don’t just pay more for stuff, we pay more for more stuff.