Inflation Errors (Part II)

Yesterday, we looked at a way to measure actual Inflation: Comparing the "spread" between the Headline CPI data, and that of the Core CPI, we learn that BLS has been consistently under-reporting inflation over the past 8 years. Since then, we have come across two related discussions that sheds additional light on the subject of accurate inflation reporting.

The first is via PIMco’s Bill Gross. In his monthly commentary, Gross observes:

"A bigger threat to asset markets however, comes not from slower economic growth in the short-term, but inflationary pressures towards the end of our secular timeframe. Note first of all the increasing influence of non-core food and energy prices in G-7 nations over the past few years as illustrated in Chart 5 for the United States. Since 1967, average differences in headline vs. core inflation have essentially been zero, despite distinct periods of cyclical variation. Now, however, with globalization so dominant and Chinese/Asian appetites for oil, soybeans, and iron ore amongst other commodities so voracious, it’s hard to envision an extended period of lower headline U.S. increases. This may bias more central banks to begin considering headline numbers in their policy decisions like Japan and the ECB do already."

Gross is referring to the Core/Headline spread we referenced yesterday. Yesterday’s graph was a bit complicated, and the chart below makes it far easier to understand the changing relationship between the Core rate of CPI inflation, and the actual Headline CPI:

Headline_vs_core

As you can see, since 2000 the Core has been under-stating inflation for some time now. And, the amount it is off by has widened dramatically. The gap between core and headline is now greater than it was in the early 1980s, and — hard as it may be to imagine — we are only slightly off the spread of the terrible 1970s.

But while we (and PIMCO) focus on the U.S. spread — the BLS reported, Fed-focused deviation from reality — others around the world have noticed the same "disconnect." A recent piece in FT by Wolfgang Munchau observed this same disconnect between inflation indices and what is experienced in the real world by consumers:

"The first time I ever began to doubt my country’s cost of living index was in 2002 when euro banknotes and coins were introduced. In Germany, where I was living at the time, the prices charged by many hotels, restaurants and dry cleaners effectively doubled. If you spent a lot of time travelling, as I did at the time, the personal inflation shock was severe. I estimated my personal inflation rate in 2002 to be approximately 10 per cent. The central bankers were in denial because the official inflation index did not register any significant movements. It must have been in people’s heads.

But this was nonsense. The problem was that the official inflation index no longer reflected many people’s personal shopping basket. The index basket is full of manufactured goods largely produced in Asia, while we spend most of our money on services, such as childcare, education, healthcare, transportation, travel and gastronomy."

That very well sums up the US experience. The basket of goods and services that is measured is so massaged and hedonically  adjusted, it manages to avoid inflation regardless.

Sometime ago on Kudlow, I debated the topic with Art Laffer (who believes there has been little inflation). But I disagree: The U.S. consumer is confronted with rapidly rising costs for food, energy, health care, housing, education expenses. Indeed, even as both the everyday survival expenses (shelter, food, energy) and the larger family expenses (Doctors, College, etc.) have exploded, there has been little correllation to what Economists and the BLS have informed them. Despite the contradiction, there is little inflation in the official stats. It is as if Economists are asking consumers "Who are you gonna believe, us, or your lying eyes?"

Munchau notes that the issue has become a global one:

"But the problem of a persistent gap between a central bank’s target price index and a separate measure used by the public has recently become more acute in the UK and the US. The Bank of England targets the so-called consumer price index, while most people in the UK sensibly rely on the old retail price index, which gives a far truer picture of the cost of living including housing. Both indices have registered increases recently. But whereas the CPI has most recently grown at an annual rate of 3.1 per cent, the RPI has gone up by close to 5 per cent. The gap between the two is large and persistent. When that happens, a central bank has a problem. On a recent visit to South Korea, I was told that the same was happening there: prices were rising everywhere, yet the price index gives the illusion of price stability."

Its time to admit that "the notion of price stability requires a broader definition. Various indices, house price inflation and the cost of rents and mortgages should all form part of a judgment about price stability." Failing to do that risk the ire of the public. They increasingly lack belief in the government  statistics in general, and there may develop a decreasing faith in Central Bank’s credibility in particular.

To paraphrase Munchau, if we are to judge inflation on a broader scale, we would undoubtedly come to the conclusion that like the rest of the world, the US has an inflation problem.

>

Sources:
How We Learned to Stop Worrying (so much) and Love “Da Bomb”
Bill Gross
Investment Outlook
PIMCO | May/June 2007
http://www2.pimco.com/pdf/IO%20May%20June%2007%20WEB.pdf

The problem with inflation indices
Wolfgang Munchau
Financial Times, May 14 2007 03:00
http://www.ft.com/cms/s/b001b8dc-01b6-11dc-8b8c-000b5df10621.html

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What's been said:

Discussions found on the web:
  1. Winston Munn commented on May 17

    It is obvious that the BLS concept of substitution is valid – recent proof was reported in the WSJ where in San Diego 100 homeowners had substituted cardboard boxes for their $750,000 homes. Those empty homes then sold at auction for 30-50% less, proving the real threat to be deflation, not inflation.

  2. Martin commented on May 17

    Inflation calculations are kept low for obvious political reasons, but the main benifit to the Government to keep this low is that entitlements & wage increases are based off of this. Therefore the political price & the cost to the US Budget to correctly state the infaltion rate is too high. This is the true reason some of the brightest minds are assigned to generate these statistacal manipulations.

  3. Winston Munn commented on May 17

    It will be interesting to see how much longer the Fed can protect its 5.25% target rate when the bond markets continue to refuse to cooperate.

  4. wally commented on May 17

    Another mark against the credibility of the Fed’s position on inflation is the statement repeated month after month: “inflation is higher than we are comfortable with”, and yet, their actions show they are comfortable with it.

  5. D. commented on May 17

    When inflation picked up in 73, it took the market quite a few years to price it in the bond market. We had to wait until 77-79 to see it truly reflected in the 5 yr bond.

    Aren’t our markets efficient? Most of the time, they are incredibly efficient at pricing in the wrong current view of things! For a short period of time they will price in reality.

  6. Richard Gatto commented on May 17

    For a true indication of inflation just look at the cost of filling up your tank at the gas station, or compare your utilities bills to what you payed last year, or just go to the grocery store where a bunch of bananas used to cost .28 – .32lb, and now cost .48 lb. When you look at inflation in that way, then it is no wonder more Americans are slipping into poverty each year.

  7. Bonddad commented on May 17

    Nice post.

    The fact that everybody talks about the core rate is such a complete sham. Here’s how I phrase it: “Raise your hand if you don’t eat food or drive a car.”

  8. madlibs commented on May 17

    If you print it, inflation will come. There is too much money all over the world. The problem is, no central bank has the balls to rein in liquidity, cause there’s so much debt collateralized by inflated asset prices that if liquidity contracts and asset prices fall, well, let’s just say that the deflation hangover could be interesting…

  9. Les commented on May 17

    According to the BLS, you can substitute cell phones and personal computers for educational services. The price indices for phone services and personal computers have dropped to less than half that of education but their corresponding weighting in the education/communication services category have risen.

    http://www.bls.gov/news.release/cpi.t07.htm

  10. bullb commented on May 17

    “the notion of price stability requires a broader definition. Various indices, house price inflation and the cost of rents and mortgages should all form part of a judgment about price stability”

    All these years the OER was understating housing inflation. I’ll bet that the new CPI calculation(if they come up with one), will use the decline in home prices to arrive at low inflation. So no housing inflation when housing went up, and low inflation when housing went down.

    Be careful what you wish for. You may get it.

  11. bullb commented on May 17

    Sorry for the italics mess. Closing italics

  12. js commented on May 17

    The Fed says that it has a comfort range of 1-2% on the PCE deflator ex energy/food. THe annual rate has been at or above that range for more than 3 years now. If they did anything to achieve their own goal, I would believe them. Their range makes sense. THey understand that the way the index is calculated, above 2% means a lot of inflation. The real problem is that they have been blatantly ignoring their own words and the fixed income markets are stupid enough to go along. When will those bond investors start demanding positive real yield?????

  13. Fred commented on May 17

    I thought the following is interesting….and a variant view.

    From Seeking Alpha:

    Signs that the consumer is getting tired are preliminary, to be sure, but evidence of persistent weakness in consumer spending, which accounts for 71% of U.S. GDP, would certainly challenge the goldilocks premise now underlying the stock market. The leading economic index we track from the Economic Cycle Research Institute [ECRI] is providing reason for optimism that the current weakness we are seeing in the economic data may be short-lived. ECRI’s leading index, which is designed to project economic conditions nine months into the future, has been strengthening in 2007 and its growth rate has just moved to a 3-year high. According to ECRI, the U.S. economic growth outlook is optimistic, which is certainly consistent with the message being sent by the buoyant stock market.

  14. M.Z. Forrest commented on May 17

    The Consumer Price Index, a big lie
    http://www.nowandfutures.com/cpi_lie.html

    What is the “real” CPI or cost of living? Is the CPI extraordinarily understated?
    Average inflation rate per the CPI (2002-2004) is 3.3% per the chart below

  15. SINGER commented on May 17

    it might be time to show that chart again where the dollar has lost 90%+ of its purchasing power since the early 20th c.

  16. Strasser commented on May 17

    Well I feel better: I believe Big Ben just said the subprime mess is in a ‘self-correcting’ pullback and will be absorbed by the financial system. Upward and onward.

  17. UrbanDigs commented on May 17

    I Agree with WSS’s comment!

  18. UrbanDigs commented on May 17

    “So no housing inflation when housing went up, and low inflation when housing went down.”

    Bullb – Great point

    I vote David Lereah as the next fed chairman.

  19. michael schumacher commented on May 17

    from the April leading Indicators report out today…..small wonder that the only two that are up are the things that the fed and treasurey cam exert the most control over…….at the very least the money supply…extrapolate that over to stock prices and you start to get the entire picture

    >>The reading tracks 10 economic indicators. Two of those readings were positive in April: stock prices and real money supply.

    The negative contributors, beginning with the largest, were building permits, weekly unemployment claims, manufacturers’ new orders for non-defense capital goods, consumer expectations, vendor performance, average weekly manufacturing hours and interest rate spread.

    The 0.5 drop means the cumulative change in the index over the past six months has turned negative.

    Spin that Fred…..

    Ciao
    MS

  20. shawn commented on May 17

    The comments above by wsss is a spam of advertisement in chinese. Please delete it.

  21. michael schumacher commented on May 17

    from the ECRI’s own web-site that is basically a Greenspan cheerleading site in disguise.

    “A new recession is certainly nowhere in sight. But keep checking those leading economic indicators over the coming months.”

    Irony or what….

    Ciao
    MS

  22. ml commented on May 17

    I can’t see the government ever revising inflation %’s to where they should be. We’re in a box:
    1) too many increased payment liabilities on so many different levels if we raise it to where it should be
    2) if we change it publicly, then something has to be done to restrain the money train and the party stops at a very inopportune moment

  23. RW commented on May 17

    I can’t help thinking of Warren Buffett’s reported response at the recent BRK shareholder meeting when asked about the potential for a credit crisis; he responded simply by saying, “The Fed doesn’t want to contract credit.”

    IMHO the spigot is not going to be turned off by this Fed or any other major central bank: The global economy may be an engine but the driver is drunk and taking swigs from the bottle while the central bankers in back are squealing, “please drive more carefully dear,” followed by, “would you like a fresh bottle” and “how do you like the high-test I filled the tank with?”

    The odds of making it home alive and well are about the same as winding up dead in a ditch; flip a coin.

    Bumper sticker seen on an LA freeway: “I hope I die in my sleep like my grandpa, not screaming like the passengers in his car.”

    More substantively perhaps, FWIW: Unless you have inflation adjusted liabilities, CPI is irrelevant and TIPS are a poor investment; buy some high-quality floaters and let the market take care of inflation concerns in real time.

  24. cm commented on May 17

    “the notion of price stability requires a broader definition”

    Maybe it requires a narrower definition. Leave out much of the discretionary spending and hedonics crap, and increase the share of the necessities facilitating modern life and functioning participation in society.

    Of course, any definition will always represent one set of value judgements or another. But different value judgements are either more or less commonly held.

  25. Fred commented on May 17

    Speaking of spin MM Chow…yes LEI dropped(.5%) in April…but you conveniently left out the prior month’s revision of up to .6% from .01%.

    And this is classic MM Chow: “from the ECRI’s own web-site that is basically a Greenspan cheerleading site in disguise.”

    Seek help.

  26. michael schumacher commented on May 17

    Yes fred I left out a revision that means very little in the overall picture since these figures are ALWAYS revised upwards to suite a particular arguement. But you know all about that.

    ECRI=paid “research”…….if you can’t or are unwilling to see that then you should be the seeker of help.

    Ciao
    MS

  27. michael schumacher commented on May 17

    Surprised no one else has mentioned this:

    Greenspan goes to work for one of his biggest critics……PIMCO manages something like $680 trillion worth of bonds….bonds do not perform very well in a “growing” economy. Did Greenie just hitch a ride on the good ship PIMCO for the begining of the recession (or at the very least some acknowledgement of it?)You know whatever he says will be treated just like he was still the FED. Falling market is good for bonds….Greenspan’s newest employer.

    Ciao
    MS

  28. RMX commented on May 17

    Guess they made him a better offer than ECRI.

  29. bart commented on May 17

    Thanks for the hat tip on my CPI lies page Fred.

    One of the more “interesting” (in the sense of the old Chinese curse) points about the BLS BS in the hedonics area is that it’s not used both ways.
    In other words – fine that PiP (Picture in Picture) on TVs means more value… but what about that plastic coated particle board dining table vs. one of real wood a while back. Why isn’t that colored with less value? … rhetorical question of course.

    The more one looks at the actual way CPI is calculated, the more John Williams data and conclusions make sense.

    Anyone can show via stats almost anything, even that inflation is going down temporarily but the bottom line is cui bono (who benefits) from the lying CPI.

    And cm – please help yourself by looking at how well and with how much warning ECRI forecasted the last recession. Bottom line – they leave much to be desired.
    My own chart has had *zero* misses and no false calls since 1960 on recession prediction, and it’s been forecasting one for almost six months now… and I believe we’re either in one right now or it will start within two months.

    http://www.nowandfutures.com/images/predict_recession.png

    The NBER will likely call it at about the time it’s over.

  30. bart commented on May 17

    ooos… make that a hat tip to M.Z., and my comment to cm should be to Fred.

  31. moom commented on May 19

    Actual inflation could be higher than the official rate but only by a little. Otherwise real GDP would have to have been declining for quite a while and that doesn’t jibe with either the reality you can see around you or any other statistics.

Read this next.

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