Should the Fed Hike Rates to Make It Rain?

If the Golden State turns more brown, should the Fed respond? Photo by Justin Sullivan/Getty Images.

The Fed doesn't and can't know the entire basket of goods and services you individually consume. It's not the NSA. (You can tell Edward Snowden to stand down.) For this reason, whatever government inflation measure you choose (the Consumer Price Index or Personal Consumption Expenditure price index or other) is unlikely to match the inflation rate you actually experience. For investors, this has potential planning implications.

Perhaps that seems simple, but many Americans conflate the two. This week, the Atlanta Fed's Macroblog ran a series of interesting-yet-wonkish articles seeking to explain the fact inflation isn't your personal cost of living. This is a point lost on all too many investors. The inflation rates the government publishes are purely a macroeconomic measure. The Fed isn't in the business of managing individuals' costs of living. What do we mean? Here are some simplistic examples:

• A 55-year old couple living in San Francisco with one child attending Stanford and one about to attend Berkeley (no athletic scholarships-these hypothetical kids are all hypothetical left feet). The couple is likely heavily exposed to both high housing costs and fast-rising tuition.
• A 70-year retiree living in Columbia, South Carolina is likely much, much less exposed high housing costs or tuition rates, but she may be more exposed to medical costs and pharmaceuticals.
• A 23-year old living in Portland, Oregon has relatively modest housing costs he splits with roommates, his parents paid for school, and he has few health care needs. But he goes out to dinner frequently and has a relatively long commute to his job. Hence, he's more subject to restaurant prices and gasoline than our other hypothetical people. He is also more exposed to areas fast deflating-technology and clothes, for example.[i]

None of these Americans are experiencing the same inflation rate. Our resident from Portlandia's primary price pressures likely aren't even on the Fed's radar screen! Food and energy prices are stripped out of the "core" gauges the Fed typically looks to.

Looking at core gauges is a frequent gripe of many inflation critics. After all, you can't live without food, and it's unlikely you live without energy. (We categorically say with exactitude that 100% of those reading this don't.) How can they claim to measure prices without these important living expenses?

The Fed's measures are a tool to gauge whether there is too much, not enough or just the right amount of money supply in the economy. Pure and simple. The Fed seeks-and they are far from perfect at this historically-to prevent the economy from overheating but keep growth going.[ii] When you factor in food and energy, you weight items outside the Fed's control, like weather or potential supply disruptions.

The Fed knowing its limits here is wise. Exhibit 1 shows the year-over-year percentage change in the core Consumer Price Index (CPI), CPI Energy and CPI Food since 1984. Consider the mixed signals these gauges seem to send at times-and the sheer magnitude of swings in energy prices. We strongly doubt the Fed has macroprudential tools sufficient to drive peace in the Middle East.[iii] California's longstanding drought likely causes higher food prices this summer, but the issue isn't monetary in nature. There are no monetary tools to make rain.[iv] Monetary policy heavily influenced by such volatile factors would be devastatingly erratic for the macro-economy. Yet rising costs of these goods are real prices you pay. They just aren't inflation. They're your changing, personal cost of living.

Exhibit 1: Core CPI, CPI Energy and CPI Food