Want to Measure Actual Inflation? See the Core/Headline CPI Spread

As we have previously discussed, inflation remains contained to the rest of the world ex-USA. Globalization be damned, there may be rapid price rises in most of the world, but there is no inflation in the U.S., thanks to a combination of hedonic adjustments and the absurd focus on the core rate.

Whenever I hear the phrase "excluding volatile food and energy" I just laugh. Can a pricing group be considered volatile if it merely goes up each month in an orderly fashion — for years and years?

That’s not volatility, thats a trend.

One way to actually measure how absurd the US core inflation measure is to look at what has happened to the spread between headline CPI and Core CPI. If Core CPI is understating inflation, than the spread should be widening. If it is accurate, the overall ratio between the two should be relatively steady.

What does the data show? The spread has increased substantially since the US adopted an ultra low rate/easy money policy under Greenspan (now affiliated with bond giant PIMCO). Since the easy money policy of the 1990s, and the  rate slashing of the 2000s, it is no coincidence that the spread between the headline number and the core has grown dramatically.

If you want to trace this widening spread back to its origins, it coincides with implementation of Boskin Commission changes in CPI. (About as intellectually dishonest analysis of Inflation as has ever been penned — its goal was to reduce Social Security payments and avoid bankrupting the US Treasury — not measure inflation accurately). Since then, the spread between the core and headline data have only grown further apart.

This simply reflects the government’s BLS inflation data diverging from reality.

Core CPI flatlined over the past 8 years because that is how it was constructed — to not show inflation. However, the absurdity of the adjustments in inflation measures is revealed in the widening spread between Core and Headline:

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CPI minus Core CPI (1980 to present)
click for larger chart
Cpi_core_spread
Courtesy of M. Ramsey King Securities

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Notice how tightly the two data series coincide (top chart) in the latter half of the 1980s and all of the 1990s? See how that starts diverging in 2001?

Bill King points out: "Targeted inflation may be the headline CPI, or a
derived core inflation measure. In either case central banks should be
aware of the sources of error and bias in their country’s CPI"

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If you really want to econo-geek out on this stuff, there are several good resources for taking apart how this data is constructed:

Core Inflation Measures and Statistical Issues in Choosing Among Them
Mick Silver
IMF Working Paper April 2006
http://www.imf.org/external/pubs/ft/wp/2006/wp0697.pdf

PCE Inflation and Core Inflation
Julie K. Smith
July 6, 2006
http://ww2.lafayette.edu/~smithjk/PCE%20core%20inflation%20070606.pdf

But the bottom line is that the US measures of Inflation, especially the core levels, are constructed to diverge from reality, and understate price rises. That is seen in the headline CPI/Core spread.

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What's been said:

Discussions found on the web:
  1. David Pearson commented on May 16

    Barry,

    Excellent post. The real test of an inflation measure: how you calculate your real returns from T-bonds. Do you use core inflation to determine the lost purchasing power of the bond face value? Or headline?

    Headline, of course. And on that basis, bond returns have been rotten the past three years. That means two things: 1) the bond market has consistently gotten its inflation forecast wrong; and/or 2) the Chinese don’t care that their real returns are so paltry.

    To the extent its 1), Greenspan, BB and the Boskin commission can be congratulated for successfully pulling the “core” wool over bond traders’ eyes.

  2. Greg0658 commented on May 16

    2) the Chinese don’t care that their real returns are so paltry

    Is Larry’s friend Rutledge on this board?

  3. Philippe commented on May 16

    « The debt cost minimisation program » has been uniform Europe US since long TIPS or regular bonds to the effect that they do not:
    Reflect the real inflation
    Reflect the risk premium US vs. Europe
    They have been manipulated by the primary dealers 2005 2006 (HSBC CS UBS sacked their bond dealers in 2006 date of arrival of the new FED chairman)
    Manipulated through media (CNBC) BNP Paribas RBS HSBC PIMCO broadcasting a recession to come in the US in 2006.
    The derivatives on the long side of the 10 years yields are equally as important as in the stock markets since 2006.
    Whoever invest in this alley has to be either stoic or well aware.

  4. nomial commented on May 16

    Just what would be the cost of COLA if the real inflation data were used?

  5. Philippe commented on May 16

    « The debt cost minimisation program » has been uniform Europe US since long TIPS or regular bonds to the effect that they do not:
    Reflect the real inflation
    Reflect the risk premium US vs. Europe
    They have been manipulated by the primary dealers 2005 2006 (HSBC CS UBS sacked their bond dealers in 2006 date of arrival of the new FED chairman)
    Manipulated through media (CNBC) BNP Paribas RBS HSBC PIMCO broadcasting a recession to come in the US in 2006.
    The derivatives on the long side of the 10 years yields are equally as important as in the stock markets since 2006.
    Whoever invest in this alley has to be either stoic or well aware.

  6. Winston Munn commented on May 16

    1) FCBs have kept bond yields artificially low.
    2) China is in a Catch-22 situation as long as the Yuan is pegged to the dollar;

  7. Adam commented on May 16

    Why doesn’t anyone just come out and state the obvious in plain language? There is a concerted effort on the part of U.S. leadership to manipulate CPI statistcs, and therefore, inflation expectations, so as to keep interest rates low, consumers purchasing, and financial institutions churning out loans. The losers are creditors that believe they are earning a small, but positive, real rate of interest, when in fact they are merely breaking even or falling behind.

  8. Fred commented on May 16

    I just read a piece from David Fry that mentions John Williams Shadow Government Statistics. It has a chart that shows an inflation rate of 6%. Interesting!

    What I find even more interesting is that that chart had inflation at a supposed rate of > 4% in 2002, as we were teetering on a death spiral of DEFLATION! The capital markets were frozen — NO CP MARKET AT ALL. Greenspan warned of a Japan syle deflation spiral. Well if we’re to believe in these Shadow Gov’t inflation numbers, Greenspan should have RAISED rates back then…does ANYONE here honestly believe that we would NOT have cratered our economy had the Fed used these numbers as legit inflation, and raised rates?

    Perspective!

  9. Jay Weinstein commented on May 16

    Here’s an irony:

    Many in the US are concerned about the large and growing income/wealth gap between rich and not-so-rich [poor is too perjorative]. Without getting too political, I think it is safe to say this is more a Democratic issue than Republican.

    However, by keeping money artificially cheap [partially a result of misrepresenting inflation], returns to capital [i.e. the rich] have been and continue to be outsized, thus increasing the gap further.

    Just a random thought.

  10. UrbanDigs commented on May 16

    so we are in trouble? Is that what you are saying? If inflation is being understated as proof by the widening spread between headline and core, then what event will occur in the future that you are fearing? Specifically?

    If inflation measures are constructed to mask what is really going on, are we going to see tighter monetary policy and a selloff in bond prices in the near future; 1-2 years?

    How will this affect asset classes? What is one to expect when the true effects finally reveals itself?

    I’m asking not stating.

  11. Greg0658 commented on May 16

    I would expect to see in a serious downturn:

    1> School bus companies taking on a 2nd schedule delivering the parents to work.
    2> Land lines of phone, cable and internet disconnected and cell phone contracts switched to pay as you go.
    3> Evening curfews to halt thievery and assalt.
    4> Restrauants selling soup, stew and tap water.
    5> Group homes and shelters.
    6> City & state budgets in turmoil.

  12. Francois commented on May 16

    I’d love to see how Don Luskin would spin that chart.

    LOL!

    Francois

  13. ml commented on May 16

    It’s very anecdotal, but my wife and I have been putting anything that wouldn’t generate an extra fee on our credit cards since the early 90s, paid off monthly. Our monthly bill always ran around $1000 to $1500 back then. It is consistently between $2500 and $3000 now. The primary changes in expenses are that we eat out less now but have higher copays on any medicines. They just about offset each other. We really haven’t upgraded our lifestyles in any way either. Rough approximation is around 4.5% to 5.5% per year in increased expenses. But, those expenses don’t include car payments, house payments, or utilities.

  14. John M commented on May 16

    Thanks for belaboring the obvious — and the great quote for Doom’s sidebar.

  15. Dan F commented on May 16

    Barry,
    I like your blog and check it every day. However the chart today was hard for me to understand.

    If you go to the St Louis Fed site: http://research.stlouisfed.org/fred2/series/CPILFENS/
    and compare to CPIAUCNS for the period from 1982 to the present it is easier to see.

    It looks like the CPI Less Food and Energy was increasing faster until about 2002 and since then the CPI All Urban Consumers has been rising faster.

  16. Nels Nelson commented on May 16

    ml,

    My experience mirrors yours exactly. We use a credit card for purchases of expenses such as food, gas, movie rentals, etc and pay it off every month. Used to run around $1,500 per month when I began doing this in the mid 90s and now runs around $3,000. Only difference between then and now is our two daughters were living with us back then and now we’re empty nesters.

  17. jimcos42 commented on May 16

    Three things:

    1. It’s helpful to develop a realistic sense of household inflation. This, of course, is totally different than considerations relating to stock and bond trading, or even asset allocation decisions.

    For the 13 years prior to retiring in 2001, I developed a household inflation rate. It came out to 2.9%. (So, for financial planning purposes, I use 3.5% to provide a Benjamin Graham-ish “margin of safety.”) Consequently, I’m not terribly hung up on “headline” inflation news.

    2. There’s an inflation calculator at the BLS site– http://data.bls.gov/cgi-bin/cpicalc.pl– that helps to get a handle on the effects of “headline” inflation over time.

    If I put in ml’s number of say, $1250 in 1993, today that would translate to $1788. Since ml reports significantly higher costs, it just means his(her?) expenses are running well ahead of advertised inflation.

    Last week I pulled out a binder with a financial plan done for us in 1997. It stated our annual need at that time was $36,252. The plan projected our 2007 expense burden to be $51,137. The BLS calculator says we would now be at $46,684. In fact, at YE06, we were at $37,165.

    We don’t feel like we’re missing a thing.

    3. I still obsessively track expenses. After spending $50 yesterday for the first time ever to fill the tank in our Camry, I came home and checked our total year-to-date fuel costs vs 2006. (We also have an Accord.)

    YTD 06= $922
    TYD 07= $819

    We’ve made no conscious effort to drive less, but obviously, sub-conscious (mindless?) things happen. We don’t work, so all our driving is discretionary. Bottom line, our personal fuel cost inflation rate this year, so far, is negative.

    Headline inflation? Interesting, but NIMBY.

    Jim

  18. K3 commented on May 16

    While we joke about the inflation sans inflation, isn’t the difference in the overall CPI and the core rate used primarily by the Federal Reserve as a way to figure out how much of inflation is structural versus incidental?

    The Fed’s manipulation of monetary policy can effect structural inflation (rising wages, goods prices) by slowing or accelerating the economy. By contrast, the Fed monetary policy tool can do little to combat incidental inflation (food/energy prices).

    Higher incidental inflation should create a wider gap between the overall and core CPI rates: As we spend more for the same amount of food and energy, we are unable to consume as many manufactured good. That the gap has widened since energy prices started to rise significantly makes sense to me.

    Keep up the excellent work.

  19. Sam Park commented on May 16

    Core CPI applies to me better than the Headline CPI.

    You know… because I live in my cabin where I buy computers and appliances, but don’t have electricity. I buy cars but never drive it. And I catch and grow all my food.

  20. peter from oz commented on May 16

    thanks Barry
    same big lie here in oz
    we lead the world (literally) in supermarket food price inflation for the past 15 years
    farm producers not keeping up with inflation
    retailers clean up
    our fuel increases less than usa but up
    yet oz govt boasts of controlled inflation
    pcm

  21. A Statistician commented on May 16

    Barry et al.,

    This morning I was conducting a literature search for works on “nonsampling error”. Coincidentally, these were two of the references that turned up in the CIS database:
    Early, J. F. (1990) Improving Consumer Price Indexes. Journal of Official Statistics, 6 (2), 179-204.
    http://www.jos.nu/Articles/abstract.asp?article=62179
    Dalén, J. (1995) Quantifying errors in the Swedish consumer price index. Journal of Official Statistics, 11 (3), 261-275.
    http://www.jos.nu/Articles/abstract.asp?article=113261

  22. Linda P. commented on May 16

    What I still can’t understand is why the incredibly powerful lobby group of the AARP does not storm the Capitol and demand a change be made in how Social Security benefits are calculated?? Why are they being so passive??

    I won’t be when I get there, but of course that’s assuming there will be anything left to fight for in 2027….

  23. sk commented on May 16

    Thanks for posting those links on Core CPI and CPI. I have the math and computing druthers for predictive analytics and really enjoy exploring its application to domains outside my expertise. I’m coming to a milestone in my current project of predicting air quality in the LA area ( look for results at my website ) and was looking for another domain to explore. Those links suggest a good area to look at.

    -K

  24. bart commented on May 17

    Yes Adam – perspective.

    What does it say about an economy and culture where 4% inflation had a teetering deflationary “death spiral”, and severe issues in credit and CP markets in 2002?

    Even using the lying and severely understated and manipulated CPI, prices have gone up about 550% since 1970.

    You apparently have a vested interest in inflation or believe we can go up forever? /sarcasm

  25. discarded lies – hyperlinkopotamus commented on May 21

    Inflation numbers are a fatuous lie, and inflation is much higher than we’re led to believe by official stats.

    Inflation numbers are a fatuous lie, and inflation is much higher than we’re led to believe by official stats.

  26. The Big Picture commented on May 22

    OER, CPI and the Fed: A Strange Love Story

    What do apartment rents in NYC have to do with Federal Reserve policy, interest rates, and rising bond yields? According to a recent analysis out of Barclay’s Capital by Dean Maki and Julia Coronado, a whole lot more than you might imagine. When April …

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