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INFLATIONS PART 2 ~!~~~ Last month's article on inflation included a ` picture of German citizens burning ' money in order to heat - their homes. Even the extremely remote possibility that money could lose so much of ~ its value that it would }~ ~ be used as tinder '~ti.: . should be enough to %'t ~~ ~ demonstrate just how .~'~~` ~~` damaging the effects ~~ ~•~~ of inflation can be. JLl ''~ Couple this with the Source: Wikipedia fact that inflation, once present, is extremely difficult to reverse, and it should come as no surprise that the primary goal of most central banks is to achieve price stability. With that in mind, we'll now take a tloser look at how inflation can be measured, before examining the tools that the Federal Reserve (Fed) uses to achieve price stability. Inflation Measures Before inflation can be controlled, it must be accurately measured. There are several different measures of inflation commonly used in the United States, and it appears that something as complex as the absolute level of inflation is difficult to pinpoint. Instead, investors would be wise to consider a variety of measures when forming an opinion as to the relative level of inflation in the economy, and then use their experience and wisdom to convert this information into an investment outlook. What are some commonly used measures of inflation Inflation can be measured at either the consumer level or the producer level. There are two primary measures of consumer inflation used in the United States: the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) Deflator. The most common measure of producer inflation is the producer price index (PPL) What is the "best" measure of inflation? The "best" measure of inflation depends on what it is being used for. PPI is an important measure of inflation at the producer level, but producer inflation tends to be extremely volatile which limits the value of these readings. Additionally, an inflationaryspiral onlyoccurs if producer price increases can be passed along to consumers. Therefore, measures of consumer price inflation are probably more important indicators of the "true" inflation level than measures of producer price inflation. Among consumer price inflation measures, the Federal Reserve and many of its members are on record that they regard the PCE Deflator to be the most accurate measure of inflation and therefore the most important determinant of the direction of monetary policy. On the other hand, CPI works very well when it is used to index payments (such as social security or wages) to consumers in order to allow them to maintain a continuous level of purchasing power for a basket of common goods. Tools of the Federal Reserve The Federal Reserve attempts to manage short term interest rates and the money supply in order to control inflation. It has two main tools that it employs in order to accomplish its goal: open market operations and discountwindow lending. Open Market Operations The Federal Open Market Committee (FOMC) of the Federal Reserve meets eight times a year to discuss economic conditions and set a target for the federal funds rate*. A "cheaper" cost of funds promotes greater levels of economic activity. Therefore, when the Federal Reserve wishes to tighten credit in order to reduce inflation, they raise the federal funds rate. When they want to promote economic activity and allow inflation to rise slightly, they lower the rate. Adjusting the federal funds rate is the primary tool that the Federal Reserve uses to combat inflation and promote economic growth. The federal funds rate is a target rate that the FOMC sets at its meetings. The Fed then attempts to maintain the target rate through the use of open market operations. With open market operations, the Federal Reserve buys and sells US Treasury and Agency securities on a regular basis in order to manage the money supply. If the Fed wants to add more money to the financial system, it buys securities. If it wants to remove money from the system, it sells securities. All else being equal, if there is more money in the financial system the inflation rate will be higher. All open market operations are conducted bythe Federal Reserve's Newyork branch. Discount Window Lending At the same time that the FOMC sets the federal funds rate, it also sets the discount rate. In theory, if the discount rate* is higher, financial institutions will be less willing to borrow from the Fed, thereby curtailing economic activity and lowering inflation. However, the discount rate is less important as a tool of monetary policy than the federal funds rate because financial institutions usually prefer to borrow from one another at the federal funds rate rather than directly from the Fed. Conclusion The primary goal of the Federal Reserve and other central banks is to control inflation. In next month's article, we'll take a closer look at how successful central banks have been at achieving this goal and what the prospects are for inflation in the global economy. Brian Perry, Vice President, Portfolio Specialist * Federal funds Rate -the rate at which financial institutions borrow and lend among themselves on an overnight basis *Discount Rate -the rate at which financial institutions can borrow funds directly from the Federal Reserve Page 2 ®2008. Chandler Asset Management, Inc. A kegistered Investment Adviser