What Wall Street knows that you don't:

There's one number everyone on Wall Street watches obsessively. The irony is, most people have no idea how it actually works. I'm going to try to explain it on one page and under three minutes. Let's go. Prices generally go up over time, like this, from point A to point B. But inflation isn't about how expensive things are. It's all about the rate of change. So let's zoom in. The overall trend is up, but how we get there might look a little different. Maybe we get there in a nice straight line with prices going up a little each month, or maybe there's a massive oil price shock and then everything flattens out. Maybe a bigger shock, big . B is always higher than A, but the pace at which we get there might go up or down. I think of inflation like walking up a staircase. All you care about is the height of each stair relative to the last. When the pace is slow, the steps are small, but if price is spike from June to July, that next step suddenly feels like you're doing a box jump. Now here's the thing. The inflation number on the news isn't just month over month. It's year over year. So you do this giant box jump, turn around to see how far you've climbed and now a giant ladder has been snuffed in right behind you because last July's number was high too. on a graph, prices in period two are still way higher than where they started in period one. But in that second period, your inflation reading might be zero. This is called base effects. Our two primary measures of inflation in the US are something called CPI and PCE. You can think of them as two similar baskets of all the stuff Americans buy and we're trying to figure out how much more it costs to fill those baskets every single month. They're similar, but a little different. The first difference is who you're actually asking. I'll come back to that in a sec. The second difference is in the weights of all the different components of the basket, like housing, transportation, food and clothing. CPI waiting only changed once a year. So if housing is 45% of the basket and transportation is 15%, they're staying that way until next year at the earliest. But with PCE, the waiting of the individual components move around continuously. PCE reacts to changes in consumer behavior in real time. If one thing becomes more expensive, most people substitute a less expensive option. So let's say the price of beef goes up by a factor of three. CPI still thinks they're eating ger every day while CPA will reflect the fact that you've switched to eating chicken. The next difference is CPA is more like a household survey where CPA reflects business receipts. It's easy to see the difference in medical care. As three patients with an MRI cost and you'll hear $300, $1500 or zero. As the hospital is 1500 each time. The cost of each individual is different, but the total cost of the hospital is the same. Now once we have all our data, we need to try to separate structural trends from exogenous shocks because the fed can't control a drought or oil prices. We have core inflation readings that strip out food and energy and super core that boils down to just essential services. So back to the federal reserve. Their preferred measure of inflation is PCE because it captures those real-time substitution preferences and takes into account purchases that are made on behalf of consumers that are made on behalf of consumers by their employees, giving them a much clearer picture of total consumer spending. That's the behavior they're trying to impact by raising and lowering interest rates along with their dual mandate of maximizing employment and maintaining price stability.