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Slightly skeptical view on core CPI

"The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists."

Joan Robinson, Cambridge University

Is core inflation  a Potyomkin Village of the real (headline) inflation ? I suspect that yes it is and as such the absolute value of core CPI

Ron Paul recently suggested that there is no a single person in the US who believes the core CPI numbers. And it really looks like core inflation systematically underestimates the real inflation by a wide margin (1% or more).  That does not mean that core inflation is meaningless: price changes in food and energy have historically exhibited less serial correlation than most other categories,  so the current trend in inflation might be visible slightly more clearly in core inflation.  

At the same time it is difficult to proved that such a simplistic approach as CPI (throwing baby with a dirty bathwater)  is better then other variants in which food and energy in included in form as some kind of average for the recent period. Core inflation is an OK concept only if you understands the limit of applicability. What is meaningless (and there is a consensus here) is the absolute value of CPI.  Taken as an absolute value  core inflation is not only underestimates actual ("headline") inflation, the measure itself is rotten to the core :-). There is probably no other area in which level of deception by Greenspan reached such heights as in the question of inflation (core inflation concept was introduced by Arthur Burns with the explicit aim to serve as a smokescreen that masks the rampant real inflation).  Greenspan resurrected CPI and advocated it with such zeal that it is clear that "great chairman" have some far from altruistic motives. But that's another story... 

One explanation of the idea of core inflation is an implicit assumption that food and energy prices are "in a long run" reverting to the mean. If this is true that CPI can filter noise from fluctuation of two pretty volatile components. Mathematically this is equivalent to assigning them the weight equal to zero. The problem is that  the recent trends in food and energy are definitely not mean reverting. Moreover at some observers suggest that if counted in an "old fashion" without all those "hedonistic adjustments" the real (headline) inflation for the last decade was around or even over  5% per year. So much for "death of inflation" hypothesis. 

There are pretty telling signs that real (headline) inflation
for the last decade was around  5% per year

Recently there are voices that real inflation is around 5%.  For example one recent (March 14, 2008) post  "Is US Inflation at 8%?"  in Naked Capitalism blog states the following:

Wolfgang Munchau, who writes for the Financial Times as well as the blog Eurointelligence, ruminates about inflation statistics and argues that economists and statisticians may be going down the wrong path in dismissing consumers' subjective perceptions. He also has considerable doubts about hedonic adjustments (basically, the methodology for adjusting for the fact that computers and other devices have become cheaper for the same performance, and that even seemingly mature products, such as cars, have features they lacked a decade ago (think GPS and more self-diagnostics).

While his post is helpful, he misses some of the other adjustments that, at least in the US, lead to the official understatement of inflation. The Boskin Commission in late 1996, which was chartered to adjust the CPI calculation (remember, at this point Social Security payments were indexed to CPI) rather conveniently concluded that CPI overstated inflation by 1.1% in 1996 and roughly 1.3% per year in prior years. And of course, the CPI methodology was then adjusted to produce lower numbers, therefore reducing Social Security payment increases.

What did the Boskin Commission think was out of line? According to Wikipedia:

The report highlighted four sources of possible bias:
Substitution bias occurs because a fixed market basket fails to reflect the fact that consumers substitute relatively less for more expensive goods when relative prices change.

Outlet substitution bias occurs when shifts to lower price outlets are not properly handled.

Quality change bias occurs when improvements in the quality of products, such as greater energy efficiency or less need for repair, are measured inaccurately or not at all.

New product bias occurs when new products are not introduced in the market basket, or included only with a long lag.
So the Boskin report would have us believe that if I switch from steak to hamburger because beef prices are up, we should only capture the change in how I consume (ie, inflation is new hamburger/old steak price, not new steak/old steak). That is patently bogus. Similarly, the outlet substitution seems rife for abuse ("Ooh, the number is going to be really bad this month! Can we find anywhere selling X cheaper so we can put that in the model instead?").

From Munchau:
... ... ...

Well, I have my doubts - and this is not a psychological argument, but a statistical one. The first thing to notice is that inflation is not an observable real world variable, such as the number of widgets produced by a factory. Inflation is a statistic - technically a mapping from a probability space of random events into the positive real numbers. To arrive at a statistic, i.e. a number, we have to take multiple decisions, such as which sample of goods to include in our basket, since we cannot measure the universe of prices. We also have to choose a method how to weigh the results mathematically. You might remember the Paasche or Laspeyres price indices taught in Economics 101. In particular, we have to choose what to put into the basket, and what not.

In the 1950s, this exercise was easy. In the UK, I was told by someone who was actually involved in this exercise that they had chosen a typical working class family, and looked at their consumption basket, which was relatively uniform by today's standards. They would pay rent, consume a certain amount of energy, obviously much of the spending went into foods, household goods, and some durables. The RPI, the retail price index, is still used today by ordinary people as their favorite measure of inflation (and also by wage negotiators). It has been significantly higher than the CPI, the index targeted by the Bank of England.

The reason for this discrepancy is, of course, related to what we put into the basket and to the adjustments we choose to make. We make lots of adjustments. If the price of a family computer at your local hardware costs €1000 today, and €1000 in one year's time, we calculate this as a fall in prices, because the quality of the computer has presumably increased. I have problems with this now ubiquitous concept of hedonistic pricing because we are double-counting. The improvement in quality is the result of a rise productivity - which is a real variable. So the improvement in quality raises nominal growth in the numerator, and it lowers the price in the denominator, in other words, we double-count the effect. It may well be that we have been consistently underestimating the rate of inflation, and overestimating the rate of real productivity growth. Since the US uses the hedonic pricing more consistently than the Europeans (I think, please correct me if I am wrong on this one), the problem would be worse in the US than in Europe.

There is a website called Shadow Government Statistics, for whose accuracy I cannot vouch, which claims that the pre-Clinton era inflation index shows current inflation at close to 8%, while opposed official CPI inflation is only half that level. Here is the chart. What makes me a bit doubtful is that the higher series is an almost perfect image of the lower series (just follow it turn for turn), so that it may be calculated as actual inflation plus x%. That would not be a very accurate way to do this.

But let us suppose for a moment that series is correct. If US inflation were really 8%, this would mean that interest rates in the US have been negative at all times in the last 10 years. It would mean that 10-year treasuries, which yield only a little over 4%, are massively mispriced, that a bond price crash of historic proportion would beckon, essentially wiping out a large amount of China's and Russia's wealth - countries that have heavy investors in the US. It would be a global economic catastrophe. So we are not going to switch back with ease and pleasure. There are many vested interests in not doing so.

I do not want to discuss the merit of this particular statistic - which I cannot - but I believe strongly that the Fed is absolutely wrong to target a core-inflation index (and it is not even doing that with any great conviction and success). Core inflation is supposed to be more stable, as it excludes volatile categories of food and energy, but both categories have not been volatile, but persistently rising. To exaggerate a little (well, ok, a lot): All the troublemakers are taken out of the basket, the rest is adjusted.

But if some of the criticisms of the modern inflation indicators are even remotely correct, it would not only mean that we are about to return to a 1970s period of stagflation, with its double-digits inflation rates in the US and in some European countries. With the Fed now swamping the market with cheap money as though there is no tomorrow, it could be a lot worse than that.

One reader wrote to me that the 8% estimate for US inflation is probably still too optimistic, as it does not fully take into account the rise in wheat and other commodity prices, for example. Another important side effect of a potentially misjudged inflation series is that US growth is actually not higher than European growth - a claim that has lead to much soul-searching over here - as we are deflating nominal GDP growth by an excessively modest indicator. As for the apparently superior performance of the British economy, just try to deflate all those nominal prices by RPI, not the actual GDP-deflator used, and the economic miracle disappears.

... ... ...

While an artificially depressed inflation indicator may make life a lot easier for a central bank, we know we cannot fool all of the people of the time. This was just tried in the credit market. Another catastrophic Ponzi game would eventually come unstuck. The last think we want after this credit crisis is over, is for central banks to put up nominal short term rates to 20% to contain runaway inflation. Contrary to popular wisdom in the US, it may be better not to cut them now, as opposed to cutting now, and hiking later.

Here are some interesting observations based on initial set of Larry Edelson:

There are also some problems with using the substitution in calculation of CPI.  As Peter Schiff noted in his July 31 2007 CNBC interview, they essentially convert this statistic metric from the cost of living to the cost of survival. He also noted:

"It does not matter what the Fed think. What's matter is reality. I don't care what the Fed think. I know what they saying. But they have an agenda"

Due to "agenda" noted by Peter the Fed are living in their own "core world" and wonders why the inflation expectation are imperfectly anchored..... As Barry Ritholtz aptly noted in  The Big Picture QOTD Bernanke on Inflation:

Peter E. Kretzmer, senior economist for Bank of America, explains (more or less) what the Fed means  by relating "inflation expectations" to the ability of the Fed to impact price rises (i.e., stability):

“This Fed much more so than prior Feds puts a very heavy emphasis on the role of inflationary expectations,” he said. “They believe, and research shows, that inflation expectations and the Fed’s inflation-fighting credibility has a large impact on private sector wage - and price-setting behavior.”

In other words, the Fed's emphasis on Core inflation -- jawboning, PR, propaganda, whatever -- is every bit as important to future prices as the actual underlying causes (excessive monetary creation, demand exceeding commodity supplies) of inflation.

I am not sure I buy that. Surely, psychology is important, and the collective expectations of either higher or lower prices can impact subsequent price behavior. 

But this approach puts the Fed into the role of a low price cheerleader, and runs the dangerous risk fo well, artificially emphasizing the irrelevant core rate of inflation rather than dealing with reality of the actual price increases as experienced by consumers.

Also the exclusion of food and energy that is practiced in calculating so called "core" inflation is a very strange idea. You can smooth the spikes in prices of food or energy by various mathematical methods but to exclude (by assigning weight zero) is perfect example of throwing the child with the bathwater.  Aka Maestro Greenspan "confidence building" trick.

 You can smooth the spikes in prices of food or energy by various methods but to exclude then is to equal to throwing the child with the bathwater.  Or need Maestro Greenspan "confidence building" (aka "consumer deception") trick.

See also Bloomberg. COM Opinion

Three years later, with crude oil prices hitting a record $78.40 in July, the CPI was rising 4.1 percent. In all that time, the price of something else should have fallen to offset the higher oil prices. The fact that it didn't means our friendly central bank was accommodating the oil-price increase, printing enough money to prevent that from happening.

For the record, the core inflation rate has almost doubled to 2.7 percent in July from 1.5 percent three years earlier.

Recently some soft but solid voices have started to challenge the Fed's choice of a core index, in part because oil prices have been ``volatile'' in one direction -- up -- for most of the last three years.

Stephen Cecchetti, professor of economics and finance at Brandeis University's International Business School in Waltham, Massachusetts, and a former research director at the New York Fed, thinks the core is an unreliable guide.

"Since the goal of policy makers is stable prices overall, including those of food and energy, they should turn their attention to forecasts of headline inflation and stop focusing on core measures,'' Cecchetti wrote in a Sept. 12 op-ed in the Financial Times.

Core inflation has been running consistently below overall inflation for the past decade by about one-half percentage point, he said. The source of the discrepancy is ``in the relative price of energy that has been persistent,'' he said in an e-mail exchange earlier this week. ``Surely, the central bank's objective should not be a biased measure of medium-term inflation.''

Based on government CPI based inflation calculator $1000 in 1995 was equal in purchasing power to $1336 in 2006. That means that you can assume approximately 30% deterioration of purchasing ability of dollar for each 10 years "in good decades" and double of than in "bad and regular decades".  In the US today, government employs 7.7 million more people than does manufacturing. Little wonder we have an $800 billion annual trade deficit when the government sector is larger than the manufacturing sector.

Also with fiat currency the tendency to abuse money printing press is the historical norm. If you assume that average annual return on 401K account is within the range of  2-6% (2.7% based on Vanguard data) then inflation alone almost guarantee zero real return for most 401K owners: you can get back only the amount of money you put into it.   That means that your pension via 401K is essentially should be self-funded.

Inflation alone almost guarantee zero real return for most 401K owners: you can get back only the amount of money you put into it.   That means that your pension via 401K is essentially should be self-funded.

Government does not publish the statistics as for average 401K accounts return (they are formally private accounts despite the fact they were created by government decree and are heavily regulated) as this will reveal far from pretty picture.  I suspect that very few, probably less then 30% of owners of 401K account, will get ahead by getting higher then 5% annualized returns. See also Inflation conversion factors for dollars 1665 to estimated 2016 to ...  and trends.  Factoring in inflation on average 401K accounts makes average returns (2.7% by some estimates) are negative and in this sense represent 401K tax. 

Actually factoring in inflation helps to see the real picture in many other areas: For example the median hourly wage for American workers has declined 2% since 2003.  [Real Wages Fail to Match a Rise in Productivity - New York Times]. If you take into account growing cost of health insurance this is closer to 5%  for some categories of professionals, the  decline of real wages was  for the same period 10% or more. 

Several years into the new century, signs abound that many professionals and their families are struggling to stay afloat in an increasingly volatile economy. Today, older trends such as job instability, downsizing and declining employee benefits are being joined by new trends like outsourcing. The result is a more fragile alliance between workers and employers—and families and the economy—in what has been called the increasing volatility of American life. At the same time that workers have become more vulnerable, their economic safety net has steadily been eroded and rising inflation is important hole in this safety net.  Unemployment insurance benefits are less generous than before and harder to come by. Health insurance is no longer a standard employee benefit and public subsidies haven’t grown to meet new demand. Pensions have changed dramatically from guaranteed retirement benefits offered by employers to an “at your own risk” 401K investment system. Finally, over the last decade, the average household has experienced stagnant or slow-growing incomes that no longer keep pace with the rising costs of housing, health care and other basic expenses. It is against this backdrop of economic and policy change that we can best understand the explosive rise in consumer debt that began in the 1980s and intensified in the 1990s. Credit card debt has almost tripled since 1989, and rose 31% in the past five years reaching almost a trillion dollars. Partially as a way to escape growing credit card debt and high interest payment associated with it, Americans cashed out $333 billion in home equity between 2001 and 2003. In fact, among the nearly half of all American households whose incomes fall between 50 percent and 120 percent of their local median income, credit card debt is most aptly described as the new “safety net” for managing essential expenses after negative event like injury, loss of job by one family member in two income families, etc.

Some people even claim that inflation numbers are maliciously manipulated. for example Charles Hugh Smit in his blog entry Is the USA a Giant Enron  made the folllowing arguments:

I. Bogus inflation numbers. I have covered this at length over the past few years; please refer to the links in this entry for more: Inflation/Deflation II: Is The Answer How We Measure? (January 9, 2007)

The best single source for information on the "real" rate of inflation (roughly 6-7%, not the phony 2% cited by our government agencies and the Fed) is John Williams' Shadow Government Statistics Analysis Behind and Beyond Government Economic Reporting.

The site has in-depth analysis of just how the CPI etc. is manipulated: GOVERNMENT ECONOMIC REPORTS: THINGS YOU'VE SUSPECTED BUT WERE AFRAID TO ASK!

A deceptively low rate of inflation is the essential Big Lie behind our economy and financial system. As Fed Chairman Bernanke often reminds us, inflation lies (pun intended) in the mind: once inflationary expectations are built into citizens' minds, inflation becomes a reality. So the key job of the government's "factoid" factories is to create the illusion of low inflation.

How can anyone be foolish enough to doubt their own experience? Hasn't anyone else noticed that gasoline prices that used to start with 2 now start with 3? Has no one else seen the costs of milk, meat, grain, education, medical care, drugs, government fees (hidden taxes) skyrocket, even as the Fed crows about the fake PCE and "core" inflation rates remaining at 1.9%?

Unfortunately, we all have the ability to ignore experience in favor of "official reality." This was starkly and sadly illustrated last year when a techie and his family became lost in the backroads of Oregon. Despite the fact that the road was unlit and unpaved and progressively becoming more primitive, the man continued to place his faith in a map he'd printed off the Web. Thus do we deny the reality in front of our noses because the "official and therefore trusted" Fed claims inflation is minimal.

Of course the deceptive practice of breaking out "core inflation" began in the high-inflation early 70s as a method of masking the inflation everyone was seeing with their own eyes. The deception worked so well that it remains a key tool in the "Emperor has no clothes" toolbox.

Want to keep that pesky entitlement spending down? Make sure the inflation/ cost-of-living adjustment to those millions of checks remains artificially low.

With the introduction of hedonics and substitution into inflation calculations in the 90s, inflation rates began to come out lower than using previous forms of measurement. so lower inflation during recent period can be partially explained by changes in the methodology of its measument.  Also CPI does not measure home prices, the area of economic where inflation has been rampant.  It measures much less inflationary thing called owner's equivalent rent. And even as house prices rose by 93% in real terms (per Professor Shiller) in the last decade, rent in real terms go up less then 50%, so the large part of growth in the cost of a new home was not reflected in the CPI.

Measured the same way as in the 1980s, inflation has been way above the Fed Funds rate for a long, long time. That was one of  the neat confidence tricks that Greenspan Fed played (another one was moving surpluses of social security collection into surpluses of budget -- fake surpluses of Clinton era).  They also sent clear signal to consumers that it's much better to borrow than save.  And that in turn further stimulated inflation but at the same time moved it from inflation of goods into inflation of assets (stocks, houses and, now, commodities). 

Investors now know all too well that official core inflation figures are a gross underestimation of real inflation. 

That not only because headline inflation is underestimated by government statistics, but also because CPI was specifically designed to reduce the weight given in the indexes to goods and services whose prices increase the fastest, as well as to underestimate housing costs.

This might partially  explain why inflation expectations are on the rise, and credibility of Fed is decline (number of jokes and nicknames for Greenspan attest this pretty clearly). That's probably why gold is having such a wild ride and might even turn into a bubble of its own. If people do not believe official figures and try to protect their investment from betting wiped out gold is the natural defensive play. Unrestrained credit expansion first fueled assets bubbles, but now this "asset inflation" moved to the prices of all commodities as well as the prices of food and medical services.

With the current drop of the dollar, 401K investors can be expected to pay a lot more for such items as medical services, fuel and food. This  translates to a lower standard of living for the same amount in 401K account even without cuts in Social Security. 

Now even mainstream press in skeptical about the rosy official picture of word with benign inflation with "core" below 2% [Bloomberg.com]:

The U.S. consumer price index continues to be a testament to the art of economic spin.

Since wages, Social Security cost-of-living increases and some agency budgets are tied to it, the government has a vested interest in keeping it as low as possible.

Yet your real cost of living -- what you keep after taxes, medical bills, college expenses and other household costs -- is probably much higher than the 2 percent annual rate the government reported in July, showing a slight decline.

Millions are falling behind inflation because wage increases aren't keeping pace with the cost of medical care, lost employment benefits, homeownership expenses, energy and transportation.

And there's also a goliath looming in the U.S. economy that makes the government's consumer gauge more deceptive. Even with the stinging reality that housing values are dropping in many markets, homeownership costs such as taxes, maintenance and financing are still rising much faster than the index."

... ... ...

Gerald Prante, an economist with the Washington-based Tax Foundation, found that median real-estate taxes on owner- occupied housing went from $1,614 in 2005 to $1,742 last year.

``That's an increase of 7.93 prcent, more than double the inflation rate in that time period,'' Prante says.

Those tax levels may sound like nirvana to a New Jersey resident, where median levies are almost $6,000.

... The single-largest expense for most Americans is housing, accounting for as much as a third of household outlays. Yet the Labor Department's Bureau of Labor Statistics only tracks ``owner's equivalent rent,'' or what a home would yield if it was rented out. Rental units and homes are two very different animals, though, and the government casts a blind eye to total homeownership expenses.

The idea that core inflation can be a proxy of real inflation might be as close to science as cargo cults. Only if energy and food are reverting to the means "in a long run" excluding them make any mathematical sense. Regular consumer pays for good and services the price inflated by headline inflation not CPI. And headline inflation is also grossly underestimated. Moreover in the current environment when energy became strategic asset and thus more tightly controlled by national governments that means that chances of energy prices reverting to some means are essentially non-existent. A good argument can be make that energy prices are now sticky and actually were sticky at least last seven years of Greenspan career. Actually Chairman Greenspan was instrumental in establishing CPI as the preferred FED measure (it was "invented" much erlier, but soon forgotten). In a way it can be called Greenspan measure and the idea was very similar of Stalin's idea of elections: "it does not matter how they vote, what matter is who counts votes."  Of course  Chairman Greenspan was expremly gifted potitian, a real master of spin.

The idiotism of using the "absolute" value of CPI are aptly explained in Bloomberg. COM Opinion

Three years later, with crude oil prices hitting a record $78.40 in July, the CPI was rising 4.1 percent. In all that time, the price of something else should have fallen to offset the higher oil prices. The fact that it didn't means our friendly central bank was accommodating the oil-price increase, printing enough money to prevent that from happening.

For the record, the core inflation rate has almost doubled to 2.7 percent in July from 1.5 percent three years earlier.

Recently some soft but solid voices have started to challenge the Fed's choice of a core index, in part because oil prices have been ``volatile'' in one direction -- up -- for most of the last three years.

Stephen Cecchetti, professor of economics and finance at Brandeis University's International Business School in Waltham, Massachusetts, and a former research director at the New York Fed, thinks the core is an unreliable guide.

``Since the goal of policy makers is stable prices overall, including those of food and energy, they should turn their attention to forecasts of headline inflation and stop focusing on core measures,'' Cecchetti wrote in a Sept. 12 op-ed in the Financial Times.

Core inflation has been running consistently below overall inflation for the past decade by about one-half percentage point, he said. The source of the discrepancy is ``in the relative price of energy that has been persistent,'' he said in an e-mail exchange earlier this week. ``Surely, the central bank's objective should not be a biased measure of medium-term inflation.''

As Dr. Marc Faber pointed out:

...study by Tom McManus of Bank of America securities who showed the composition of inflation.

The Bureau of Labor Statistics has calculated that health care inflation in the last ten years or so averaged about 4% per annum. However, from private studies we know that health care costs have risen by around 10% per annum in the last few years. Moreover, whereas the weighting of the BLS's health care expenditures within the CPI is only 6%, health care represents about 17% of consumption, and this, so Bill King points out, according to the Bureau of Economic Analysis of the US Commerce Department.

I think there is no better example to expose the US government's continuous lies about the health of the economy. By understating the rate of CPI inflation the bond market is being fooled and real GDP growth rates artificially boosted since real GDP is nominal GDP less the rate of inflation. So, if nominal GDP increases by 6% and inflation instead of averaging 3% per annum is in fact more likely to average 5% per annum, real GDP growth is not 3% but 1% per year!

As a side, I may add that I have always been skeptical about buying inflation adjusted bonds (TIPS), simply because the yield on inflation adjusted fixed income securities is pegged to the CPI. Since the government will always understate the true rate of inflation the buyer of the TIPS will eternally be shorthanded. Moreover, I think that one day in future, the bond market will finally wake up to the fact that inflation has been understated and sell-off very badly.

In fact, you would have to be the world's greatest optimist (a la Abby Cohen or Larry Kudlow) to buy a US 30-years government bond in US dollars and with a yield of just 4.5% with the view to hold these bonds to maturity. You would have to assume that US inflation will never rise above 4.5% within the next 30 years and that the US dollar's purchasing power will be maintained. Not a likely scenario, in my opinion (short term, however, bonds couldally somewhat more as the economy weakens).

But there is another reason why I started out by talking about markets moving ahead of news. Recently a board member of one of the asset allocation funds, for which I am also an advisor, wanted to double the equity allocation of the said fund based on an economic study he circulated (naturally produced by a self serving investment bank), which showed that the global economy was strengthening and that profit growth would remain strong.

The history of CPI was described in recent New York Tribute article CPI fraud directly linked to subprime credit crisis in the following way:

In 1983, the Bureau of Labor Statistics was faced with an awkward dilemma. If it continued to include the cost of housing in the Consumer Price Index, the CPI would reflect an inflation rate of 15 percent, thereby making the country's economy look like a banana republic. Worse, since investors and bond traders have historically demanded a 2 percent real return after inflation, that would mean that bond and money market yields could climb as high as 17 percent.

The BLS's solution was as simple as it was shocking: Exclude the cost of housing as a component in the CPI, and substitute a so-called "Owner Equivalent Rent" component based on what a homeowner might "rent" his house for.

The result of this statistical sleight of hand was immediate and gratifying, for the reported inflation index quickly dropped to 2 percent. (This was in part because speculators needed to offset their holding costs by renting out their homes while their prices skyrocketed, thereby flooding the market with rentals that pushed down the cost of renting a house or apartment.)

While the BLS was correct in assuming that this statistical ruse would fool the average citizen into believing that inflation was only 2 percent (and therefore be willing to accept a meager 4 percent return on his bank savings), what is remarkable is that the ruse also fooled the bond traders, and apparently continues to do so, leading analyst Peter Schiff to describe these supposed savvy bond traders as the "hormonal teenagers of the capital markets."

The present subprime credit crisis can be directly traced back to the BLS decision to exclude the price of housing from the CPI. It is now clear that the "benign" inflation figures reported over the last 10 years in no way reflected the skyrocketing rise in home prices, with states like California experiencing annual home-price increases of as much as 30 percent. With the illusion of low inflation inducing lenders to offer 5 percent and 6 percent loans, not only has speculation run rampant on the expectation of ever-rising home prices, but homebuyers by the millions have been tricked into buying homes even though they only qualified for the "teaser" rates that quickly escalated to unaffordable levels. As long as home prices continued to skyrocket, buyers could refinance based on the increased value of their equity as collateral; but once home prices stabilized and even declined, many families were forced into foreclosure.

Based on government CPI based inflation calculator $1000 in 1995 was equal in purchasing power to $1336 in 2006. That means that one can safely assume at least 30% deterioration of purchasing ability of dollar for each 10 years or approximately 2.4% a year (in Excel: power(1.336,1/12)=1.024433735).

A real CPI would’ve eradicated most it not all of GDP growth.  And the more realistic GDP figure would be more in line with the lack of growth in real income and ‘real’ jobs.

Also in the US today, government employs 7.7 million more people than does manufacturing. Little wonder we have an $800 billion annual trade deficit when the government sector is larger than the manufacturing sector. That's tells also a lot about the claim of "free market" economy. And with fiat currency the tendency to abuse money printing press by the government is the historical norm. If case of war exceptions are unknown. If you assume that average annual return on 401K account is within the range of  2-6% (2.7% based on some data) then real inflation alone  guarantee negative real return for most 401K owners: you can get back only the amount of money you put into it.   Actually slightly less as 401K owners are indirectly subsiding the government. 

As reflected in the plummeting dollar, many of the 401K gains of the past few years were purely inflation driven, nominal asset price increases -- not real (after inflation) gains.

As reflected in the plummeting dollar, many of the 401K gains of the past few years were purely inflation driven, nominal asset price increases -- not real (after inflation) gains.

Government does not publish the statistics as this will reveal far from pretty picture but I suspect that very few, probably less then 20% of owners of 401K account, will get ahead by getting higher then 4.5% returns. See also Inflation conversion factors for dollars 1665 to estimated 2016 to ...  and trends.  Actually factoring in inflation help to see the real picture in many other areas: For example the median hourly wage for American workers has declined 2 percent since 2003.  [Real Wages Fail to Match a Rise in Productivity - New York Times]. If you take into account growing cost of health insurance this is closer to 5% and, for some categories of professionals, 10% decline of wages.  Here is how the this problem was described in Financial Sense  in  June 2005:

In the early 90’s the government realized it had a problem with rising entitlement costs for Social Security, Medicare, and government pensions. These entitlement payments were indexed by the inflation rate each year. With inflation on the rise it meant these costs were rising faster, thus making government deficits much worse. In order to bring the government deficits under control, it would be necessary to bring rising entitlement costs down.

One way to lower entitlements would be to bring the inflation rates down, which would translate into lower Cost of Living Adjustments (COLA). The way to do this was to bring down the rate of inflation. However, this was not done by natural means, but artificially through statistical manipulation. The supply of money and credit began to go parabolic in the 1990s as shown in the graph of M3. The rise in money and credit would mean higher inflation rates. Higher inflation rates would mean higher COLA adjustments, which would lead to bigger deficits.

The solution was to change the way inflation is measured. Media reports began to surface on how CPI was overstated. The real inflation rate was actually much lower according to government and Federal Reserve officials. The Senate Finance Committee appointed the Boskin Commission to study the problem and find a solution. The Boskin Commission published its final report ”Toward a More Accurate Measure of the Cost of Living,“ and submitted its findings to the Senate on December 4, 1996. The Boskin report recommended downward adjustments in the CPI of 1.1%. The CPI, which is used as the basis for COLAs to Social Security and government pensions, if lowered as recommended by the commission, would reduce future entitlement payments as well as impact other government programs. The CBO estimated that by overstating CPI by 1.1% it added $691 billion to the national debt by 2006. By then the annual deficit would rise anywhere from $148 billion to $200 billion annually by overstating the inflation rate. In effect the government was overpaying because the actual inflation rate was much lower.

The Boskin Commission recommended several changes to the CPI index which included:

The result of their implemented suggestions is the mish mash we have today, which bears no resemblance to reality. The Commissions recommendations had widespread support in the Clinton Administration, a Republican Congress and from financial luminaries such as Alan Greenspan, who was expanding the money supply at a very rapid rate as shown in the graph above.

Substitution
Up until the Boskin/Greenspan initiative surfaced the CPI was computed each month using a fixed basket of goods. That changed after the Boskin Commission. The Bureau of Labor Statistics (BLS) began using substitutions in their monthly computations of the CPI. If beef prices rose, it was assumed that people substituted chicken. If chicken prices rose, then consumers would switch to fish. If all these prices rose, well consumers would become vegetarians or maybe start eating Alpo.

Weighting
In addition to changing items in the index through the substitution principal the BLS also changed the weights of items in the index. Instead of straight arithmetic weightings the BLS began to use geometric weighting. The benefit of geometric weighting is that it automatically gave a lower weighting to those items in the CPI that were rising in price and higher weightings to items in the index that were falling in price.

As an example of how geometric weighting can produce lower values, a recent example from the 90’s bull market will illustrate the point through two Value Line Indexes. The indexes are essentially the same. They are made up of 1650 stocks. One index is arithmetically weighted and the other is geometrically weighted. Between January 1990 and December 2000, both indexes—which include the same stocks—produced totally different outcomes and returns. The geometric index peaked in April 1998. The arithmetic index did not reach its first peak until May 2001. The return from January 1990 to December 2000 was 52% versus over 300% for the arithmetic index. The geometric index peaked in 1998, while the arithmetic index did not reach its first peak until 2001. Since 2001 the arithmetic index has gone on to reach new a new high on 6/17/05, while the geometric index has never recovered from its peak in 1998. This is just one example how geometric weighting can produce lower outcomes not only in stock market indexes but also in inflation rates.

Hedonics
The manipulation didn’t stop there. The bureau also began to adjust prices for quality. This practice became known as hedonics. Hedonics adjusts the prices of goods as a result of the increased pleasure a consumer derives from a product. A few examples will illustrate how removed the index has moved away from reality. Tim LaFleur is a commodity specialist for televisions at the BLS. In December last year he adjusted the price of a 27-inch television set for quality improvements. The 27-inch television set had a retail cost of $329.99. However, he decided the new model, which still sold for $329.99, had a better screen. After putting this improvement through the governments complex hedonic adjustment model he determined the improvement in the picture was worth at least $135! Taking in this improvement he adjusted the price of the TV by $135, concluding that the price of the TV had actually fallen by 29%! [1] The price reflected in the CPI was not the actual retail store cost of $329.99, but $194.99. The only problem for we consumers is that if we went to Best Buy or Circuit City to buy that TV, we would still pay $329.99.

Another example of hedonics at work is the way the BLS treats rising automobile prices. Mr. Reese, a specialist for autos, took a 2005 model car, which went from $17,890 in 2004 to $18,490 in 2005. After adjusting for quality items and making antilock disc brakes standard, the bureau adjusted the actual $600 price increase down by $225. The problem for we consumers is that the price of the car in dealer showrooms was still $18,490.

The Substitution Effect
Substitution also plays a role in reducing the CPI. From 2001-2003 the CPI index fell by 1.6% reaching a low of 1.1%. Wall Street and the Fed were talking about the risk of deflation. Deflation was predicted everywhere in the press. The financial world became fixated over the risk of deflation even though the monetary presses were working overtime, credit was mushrooming, and asset bubbles were inflating in the mortgage, bond, and real estate markets. The reason for the decline was the substitution effect. Instead of using new car prices, which were going up each year, the BLS substituted used car prices, which were falling. In place of exploding real estate prices, the Bureau gave more weight to the price of rents, which were falling as more households bought homes. Rents were given more weight even though 69% of households own a home versus the 31% that rent.

What makes this look even more ridiculous is that in April the National Association of Realtors reported a year-over-year price increase in homes nationally of 15%.

Year Over Year Increase In Household Residential Real Estate Values ($billions)
2000 2001 2002 2003 2004 Through 3Q Cumulative
$1,010.3 $1,088.7 $1,197.0 $1,430.5 $1,601.7 $6,328.4

Source: Don't Ask, Don't Tell 

One has to wonder as what kind of creativity will be used now that rents are starting to rise as apartment owners remove lease incentives. Perhaps the hedonic models will begin adjusting rising rents downward due to changes in the quality of amenities such as swimming pools, running water, magnificent views of the freeways, or the artistic effects of polluted air in creating colored sunsets.

Many homeowners may not be aware that as a homeowner they receive a fictional income referred to as Owner’s Equivalent Rent (OER). Essentially the BLS samples the price of rents in residential housing to come up with what a homeowner would receive hypothetically if they were to rent their own home. That sounds idiotic to me, since most homeowners would agree the family castle is in many cases a money pit and not a source of income. Unless the home is owned free and clear, most homeowners have cash outgo each month due to mortgage payments, property taxes, utilities, and repairs. As absurd as this concept appears, OER gets the largest weighting in the CPI index of 23% versus actual rent, which gets only a 6% weighting. OER is purely fictional, yet it carries the greatest weight within the CPI index.

Hedonics helps the BLS keep rising prices for goods in the CPI from ever showing up as rising prices. Even though the cost of housing, energy, food, medical bills, prescription drugs, tuition, and entertainment have soared, the government keeps reporting moderate inflation. Hedonics is partially responsible. It has become a convenient and subjective way of removing prices increases from the CPI. The combination of substitution, changing the weight of goods rising in price, hedonics and seasonal adjustments is one reason why the CPI and reported inflation has remained as subdued as it is reported each month. The problem is that these numbers are all fictional and bare no resemblance to what households face each month with their actual budgets.

Seasonal Adjustments
As if these distortions weren’t enough, there are the seasonal adjustments that remove the price increases that occur during certain times of the year, i.e. gasoline prices during the summer driving season or heating oil during the winter. Seasonal adjustments are nothing more than “intervention.” They are designed to remove or scale down volatility or price spikes. The only problem is that price spikes never show up in the CPI. Only price drops get recorded. Price spikes are statistically smoothed away so they never show up. Sharp spikes in oil, gasoline, heating oil, or food get statistically adjusted. This keeps the CPI low. It is why the caller at the beginning of this article was puzzled. What consumers see everyday in real life is so different than what the government reports and the markets accept each month. It is unreality TV.


Spin City

Another way of understating the CPI is the “core rate," which is a nonsensical phrase that is commonly used in the financial world. Whenever the CPI rises, they back out food and energy to give us the core rate, which is much lower. Whenever the CPI rate goes lower, they refer to the CPI rate and not the core rate as they did this month. The CPI fell 0.1% in May from April. It was the first decline in 10 months. The drop was due to falling energy prices. Oil prices started out the month of May at $53.56 a barrel. They fell to $49.65 mid-month before rising back to $52.75 at the end of the month. Did the drop of $.81 really account for a drop in the CPI of 0.10%? If the CPI is as moderate as the Fed claims, then why are they raising interest rates? Could it be inflating asset bubbles, such as real estate, mortgages, and consumption, the imbalances in our trade deficit or expanding annual credit of $2.7 trillion? They haven’t really told us.

Finally, let’s clear up the other nonsensical notion of excluding energy. Energy is essential to industrial economies. It takes energy to extract raw materials from the earth. It then takes energy to manufacture the things we use and consume. It also takes energy to transport the goods we produce. Even the energy we consume takes energy to produce whether it is oil, natural gas, or electricity. Petroleum products contribute about 40% of the energy we use in the United States each year to other products that we never think about.

Transportation accounts for an estimated 67% of all petroleum use in this country. The rest is accounted for by nonfuel products and petrochemical and feedstocks. The list below from the EIA/DOE is not exhaustive, but is illustrative of the many uses of petroleum.

Nonfuel Products

“Nonfuel use of petroleum is small compared with fuel use, but petroleum products account for about 89 percent of the Nation's total energy consumption for nonfuel uses. There are many nonfuel uses for petroleum, including various specialized products for use in the textile, metallurgical, electrical, and other industries. A partial list of nonfuel uses for petroleum includes:

• Solvents such as those used in paints, lacquers, and printing inks
• Lubricating oils and greases for automobile engines and other machinery
• Petroleum (or paraffin) wax used in candy making, packaging, candles, matches, and polishes
• Petrolatum (petroleum jelly) sometimes blended with paraffin wax in medical products and toiletries
• Asphalt used to pave roads and airfields, to surface canals and reservoirs, and to make roofing materials and floor coverings
• Petroleum coke used as a raw material for many carbon and graphite products, including furnace electrodes and liners, and the anodes used in the production of aluminum.
• Petroleum Feedstocks used as chemical feedstock derived from petroleum principally for the manufacture of chemicals, synthetic rubber, and a variety of plastics.

Petrochemical Feedstocks

Petroleum feedstocks have been used in the commercial production of petrochemicals since the 1920's. Petrochemical feedstocks are converted to basic chemical building blocks and intermediates used to produce plastics, synthetic rubber, synthetic fibers, drugs, and detergents. Naphtha, one of the basic feedstocks, is a liquid obtained from the refining of crude oil.

Petrochemical feedstocks also include products recovered from natural gas, and refinery gases (ethane, propane, and butane). Still other feedstocks include ethylene, propylene, normal- and iso-butylenes, butadiene, and aromatics such as benzene, toluene, and xylene. These feedstocks are produced by processing products such as ethane (separated from natural gas), distillates, naphthas, and heavier oils.

Industry data show that the chemical industry uses nearly 1.5 million barrels per day of natural gas liquids and liquefied refinery gases as petrochemical feedstocks and plant fuel. 10 Demand for textiles, explosives, elastomers, plastics, drugs, and synthetic rubber during World War II increased the petrochemical use of refinery gases. Gas byproducts from the production of gasoline are an important source of many feedstocks.[2]”

As shown above from the government's own energy information sheets, the use of petroleum is critical to our modern industrial way of life. Does it really make financial sense to remove it from an inflation gauge that is used to assess the cost of living? Think of what life may become without energy. We may soon find out, if peak oil is really here. With the price of energy at $60 a barrel, excluding its rise from the cost of living is as impractical as it is disingenuous.


Obfuscation

The “core rate” is a fictional concept designed to sooth the financial markets and distract them from the reality of rising inflation. The core rate does not exist anywhere in our economy. It is a fictional concept designed to obfuscate inflation.

The next time you go to the grocery store and experience shock and awe as the checker rings up your shopping cart, ask him or her for the “core rate.” See what kind of look you get. For that matter, when it comes time to make your monthly mortgage payment, instead of making the payment, send a bill to your lender for “owners equivalent rent.” And the next time you pay your taxes in any form, whether income or property, hedonically adjust the bill for the lower quality of government service. If your tax bill went up, just use hedonics to adjust the bill downward. Ah, you might say, "This is impractical. Nobody can ever get away with that." You would be right, but perhaps it is a question we must now ask of government. Somebody should start questioning the reported inflation numbers as our caller did at the beginning of this article. Problems can only be solved when they are acknowledged first. Washington, we have a problem: it is inflation, not deflation.

What needs to be monitored next as the US economy falls into recession and perhaps depression is what happens to money and credit and the price of the dollar. If credit expands and if the Fed or foreign central banks print money to buy our bonds, where will the next asset bubble occur? As long as we live in a world of fiat currencies with no backing to any of the world’s currencies central banks are free to print as much money as they want. There is nothing to stop them from doing so. What we have seen in this new fiat world is that when money and credit expands rapidly there are always sectors that will inflate and others that will deflate. As the technology bubble deflated, three bubbles in bonds, mortgages and real estate took its place. During this time, while new assets bubbles were in the process of inflating as one asset bubble deflated, the CPI fell and was cut in half, giving sway to the argument of deflation. In reality, the only deflation that was taking place was at the BLS in its substitution and hedonic statistical models.

The deflationist’s argument that inflation only takes place during times of war and expanding government budgets isn’t necessarily true. War or expanding budgets aren’t necessary for inflation to occur. Prime examples are Latin America, more recently Argentina, Brazil, Turkey and Russia, as is the Weimar Republic. If deflation takes hold in the US, it won’t be as the deflationists now see it. It will be as result of the currency falling faster than the rise in nominal prices as it occurred in Weimar Germany.

Given the size of mortgage debt and the amount of leverage in our economy and financial system the Fed will not tighten rates in a significant way. The table listed below, taken from the current bond market and John Williams' real CPI, shows just how far behind current interest rates are from real inflation rates.

REAL NEGATIVE INTEREST RATES
Real CPI 5.5%
Federal
Funds		 1 Yr
T-Bill		 2 Yr
Note		 5 Yr
Note		 10 Yr
Note		 30 Yr
Bond
3.25% 3.48% 3.62% 3.73% 3.95% 4.25%

INFLATION DEFICIT
<2.25%> <2.02%> <1.89%> <1.77%> <1.55%> <1.25%>


Source: John Williams' Shadow Government Statistics, gillespieresearch.com

As the US debt burden increases with each passing month, the Fed has only one option, which will be to print money. Up until now foreign central banks have relieved the Fed of most of that burden. Foreign central banks have been doing most of the money printing in an effort to sterilize capital inflows into their countries and keep their currencies from appreciating.

This issue has become more serious than is commonly recognized. According to the latest Q1 2005 Z.1 “Flow of Funds” report first quarter non-financial debt expanded a record $2.411 trillion. As Doug Noland reports in his June 10th Credit Bubble Bulletin, during the decade of the nineties non-financial debt expanded on average $700 billion annually. Blow-off credit creation is now more than three times the pace. [3]

Consider these facts from Doug Gillespie Research:

The following table taken from the same Gillespie report shows just how much of our debt has been acquired by foreigners in the last decade. The Fed has had little need to monetize debt. Foreigners are doing the Fed’s dirty work.

FOREIGN HOLDINGS OF U.S. SECURITIES

 Security

 03/31/2005 12/31/2004 03/31/2004 12/31/1994
 Treasuries 43.0% 42.5% 40.1% 18.3%
 Agencies 13.2% 12.7% 11.2% 5.7%
 Corp. Bonds 27.3% 26.6% 25.3% 13.4%
 Corp. Equities 13.4% 13.0% 12.4% 7.0%

Source: Gillespie Research / Federal Reserve

In effect, the US is exporting its inflation and it will ultimately result in deflation in the rest of the world, which is heavily laden with overcapacity and hyperinflation in the US when foreigners no longer finance our deficits. That is when the end game of hyperinflating our way out of our debt bubble really begins. Unlike the gold standard, there are no self-correcting mechanisms in the global monetary system. The dollar or any other currency for that matter has no intrinsic value. All currencies are fiat and have no limit to the amount of its supply. There can be no dollar short position as some imply, because by its very nature the supply of dollars is unlimited as the above statistics illustrate.

The real risk is what happens when confidence in the dollar wanes as it must. Like the Weimar Republic, which had its currency accepted as a means of payment during the initial stages of inflation, the gig was up once foreigners realized the full extent of the mark’s depreciation. That is when they began disposing the mark and the hyperinflationary stage was set to unfold.

What we can say now is that the US is experiencing real inflation in the economy that is much higher than what is reported (6-8%). In addition to real inflation in the economy, the US has experienced hyperinflation in the financial economy—first in the stock market (the tech bubble between 1995-2000) and then in the mortgage, bond and real estate markets since 2000. If inflation continues to increase as I suspect in the real economy, I can guarantee you it will never show up in the CPI and PPI. Real inflation will be removed statistically through the magic of hedonics, geometric weighting, substitution, and seasonal adjustments.

This whole process of purposefully understating the real inflation rate also keeps real inflation artificially subdued. Think of all of the aspects of our economy that are tied to the CPI. Listed below are just a few examples:

Labor contract negotiations begin with CPI adjustments. Annual raises at companies are based on CPI changes. Think of how many workers fall further behind in their pay because of an understated CPI. How many landlords are cheated out of their just rents by understated inflation rates? How many retirees are robbed of real increases to their pensions as a result of underreported inflation? What would be the real rate of interest, if bond investors figured out that the real inflation rate was 6% and not 3% as reported by the BLS.

An understated CPI also overstates GDP by not removing the full inflationary impact of pricing from nominal numbers. It also overstates productivity by overstating the numerator part of the equation.

Any debate over deflation or inflation must begin with the truth. By habitually pointing to an understated CPI as proof that inflationary forces remain moderate is disingenuous at best and fraudulent at its worst. The truth is that we are experiencing real inflation rates of 6% in the real economy and hyperinflationary rates in the financial economy in bonds, mortgages, and real estate. When the next downturn comes, it will most assuredly alert investors to keep a sharp eye out for the next asset bubble to hyperinflate. Will it be stocks as occurred in the Weimar Republic, Japan and the US? Will it be hard assets such as gold, silver, and other hard commodities as has occurred throughout all of history when governments inflate?

What we have now is inflation. Forget the CPI, PPI, and the ”core rate.” These are all fraudulent inflation gauges designed to confuse and obfuscate the real inflation issue. There is no such thing as the “core rate.” The core rate doesn’t exist in the real world. Next time you see an increase at the grocery store, the gasoline station, your utility or cable bill, your children's tuition, your property taxes or your dentist's or doctor's bill, ask for the “core rate.” That is when you will be confronted by the reality of its fiction.

P.S. The inflation/deflation debate will be showcased on the FSN network with both sides making their case. Bob Prechter was the first guest, Dr. Marc Faber, and John Williams will be next in line.

P.P.S. A lengthy piece on hyperinflation will be written making its case after my summer sabbatical in August. Part II of "The Great Inflation” coming sometime in late September early October. The piece will be lengthily and may be published in four parts due to the length of its contents. I’ve got Mary worried, because it’s beginning to look like “War & Peace.”

P.P.P.S. As many are fond of making bold predictions, I’ll make a few here.


TEN REASONS FOR HYPERINFLATION

  1. Global oil production will peak between 2005-2008. Economic growth ceases to exist as global economies and markets are thrown into chaos and turmoil.

  2. The War on Terror escalates into a resource war over oil pitting the great powers the US, China, and Russia in a replay of “The Great Game.”

  3. Debt creation and monetization hyperinflates as the government’s deficit spirals out of control with a war and a depression.

  4. Foreigners begin to bail out of the dollar setting off a dollar crash.

  5. The US puts in place capital controls to corral US and domestic money. The War on Terror will be given as the reason.

  6. The government takes over GSEs owning most American mortgages.

  7. A national mortgage bailout bill is passed lengthening mortgage payments in an effort to forestall debt defaults. A new restructuring agency will be set up to repurchase impaired mortgages from the banking system and renegotiate terms of the debt to avoid default. The 100-year mortgage is born.

  8. A national retirement security act is passed forcing private pensions to buy long-dated zero-coupon government bonds that will be inflated away. The reason given will be for plan protection against bear markets.

  9. As the US economy goes into a hyperinflationary depression the rest of the world’s economies follow suit. Money printing on a grand scale occurs in western and Asian economies as governments wrestle and try to satisfy the demands of a social welfare state and an angry, aging populace.

  10. As governments hyperinflate and debase their currencies, gold will take on its true role as money rising in value against all currencies. The world will move towards a global currency backed by gold.

I have a few more, but these first ten should do for now.

Old News

Mish's Global Economic Trend Analysis

... The CPI is the most widely accepted measure of a "representative basket of goods and services" so let's start there.

Consumer Price Index - Urban Consumers - All Items



click on chart for sharper image
The above chart courtesy of St. Louis Fed.

The CPI itself is running at 5.6% vs. a year ago.

Please consider the following chart on Real Interest Rates.

Real Interest Rates



click on chart for sharper image
The above chart courtesy of Martin Capital Advisors

So far all I seem to have done is verify just how preposterous my claim was. The above chart shows that Real 91-date T-Bill is running close to -4%, and the long bond is running close to -1%.

Are Real Treasury Rates That Negative?

The answer is no they are not, assuming one uses a "representative basket of goods and services" by which to judge.

Earlier I stated the CPI was the most widely accepted measure (and it is), but that does not mean it is truly "representative" of anything.

Inquiring minds no doubt are now asking "What's wrong with the CPI?" It's a good question too. The big problem is housing. Home prices are crashing and those prices are not adequately reflected in the CPI. Instead, the single largest component of the CPI is "Owners Equivalent Rent". OER is a process in which the BEA estimates what it would cost if owners were to rent the homes they own from themselves. I do not believe this to be a valid construct of prices.

By ignoring housing prices, the CPI massively understated inflation for years. The CPI is massively overstating inflation now.

In normal times with rents in sync with home prices, it did not matter much if one used OER or actual home prices. It's a remarkably different story now. We have just seen the biggest housing bubble in the history of the world. At the peak of insanity, home prices were 3 standard deviations above rental prices and 3 standard deviation above wage growth.

Now, the important factor is that home prices are crashing, with quite a big drop still needed to get back to historic norms. With that in mind, housing can be expected to be weak for quite some times.

The treasury market seems to have figured all this out quite nicely. Pundits screaming "treasury bubble" clearly have not.

Case-Shiller vs. Owners Equivalent Rent

Case-Shiller shows that home prices have declined 15.4% over the past year. Currently, OER is the largest component of the CPI at nearly 24%.

A CS-adjustment (substituting Case-Shiller for OER in the CPI) would knock 3.7% off the CPI (15.4 * .24).

We must also take into account the reported OER was +2.6 vs. a year ago. It's affect on the CPI is (2.6 * .24) or .624 of the reported 5.6%. Rounding to the nearest tenth, another .6 needs to be subtracted from the adjusted CPI. (5.6 - 3.7 - .6 = 1.3)

This would make the CS-CPI +1.3% instead of the reported 5.6%

BLS Verification

I contacted Steve Reed at the BLS to confirm my numbers. Steve came up with the same number although it was via a slightly different method. Mathematically I believe they are the same, but the important point is the verification of the number itself.

Steve Reed writes:
I did an example based on the OER declining 15.4 percent. I get a result that this would cause the all items index to increase 1.3% instead of 5.6%

I decomposed the AI index into OER and AI less OER. The easiest way to do this is just to give each index a base of it's relative importance, which automatically weights things correctly and makes the indexes additive. So, the all items index is literally the rebased OER index + the All items less OER index, So, when you do a hypothetical OER, you can just add it back to the All less OER to get a hypothetical All items.

Since there was a new set of weights put in during the middle of the period we are studying, this isn't precisely accurate--to really have the exactly correct weight for OER during each time period would take several steps and be a real pain--but the error should be small.

Steve Reed
Thanks Steve!

CS-CPI vs. Real Long Term Averages

CS-CPI is +1.3%

Real 3 Month Treasury Yield vs. Long Term Average
 
Real 30 year Long Bond Yield vs. Long Term Average
 

Factoring in home prices, real 3 month treasury yields are a bit under long term averages while the 30 year long bond yields are a bit over long term averages. This assumes Case-Shiller is an accurate representation of home prices. I believe Case-Shiller declines are understated because they ignore homebuilder discounts on new home sales. (Case-Shiller only looks at repeat sales of the same property).

If one assumes like I do, that home prices are really down 20% then the CPI (using the same methodology) is approximately .2%, real 3 month treasury yields are +1.52, and real 30 year long bond yields are 4.21%. Either way, the above numbers are a shocking difference from the reported numbers.

Do home prices belong in the basket?

I have had many people over past year tell me they do not care about home prices because they rent, or tell me that do not care about home prices because they own their home outright, or tell me they do not care about home prices because their house is a long term investment.

People may not care (or more realistically they may think they do not care), but the treasury market sure cares about something, and the most likely something is the destruction of wealth in housing along with the ramifications the housing market has on bank credit, corporate earnings, consumer attitudes, etc.

It's true that a person does not buy a home every week but that same person does buy food and gasoline every week. However, that does not make the price decline any less real. More importantly, it is naive to think treasuries should ignore the ongoing destruction of wealth in housing and the bank writeoffs that bust is causing.

Let's look at this from a practical standpoint. What's more important, home prices dropping $50,000 to $250,000 in value over the course of a few years or the price of gasoline going from $2.00 a gallon to $4.00 a gallon over the course of those same few years?

From a macro-economic standpoint, the correct answer to the above question is housing even though consumers were constantly griping about gasoline prices until the recent selloff. The easily seen is gasoline price hikes because people buy it every week. Practically speaking, the destruction of housing wealth matters far more. Here is the question to ask: How many tanks of gas will it take to equal the loss of $50,000 on a house?

On this basis, the so-called "irrational behavior" of the long bond specifically, and the entire treasury curve in general, does not seem so irrational.

Unprecedented Housing bubble

In previous decades, rental prices and home prices were basically in sync. In that model it would not have made much difference in the CPI whether OER or actual home prices were used to calculate the CPI. It makes a huge difference now.

More recently, housing prices soared 3 standard deviations above norm vs. rental prices. And while prices were rising, the CPI was enormously under-stated. Now the CPI is horrendously over-stated.

Let's do a little reality check.

Does anyone believe credit to be looser and inflation faster now than when home prices were soaring 100% or more year over year? I don't, but that's what the chart from Martin Capital Advisors shows. By the way, I am not critical of that chart. It is what it is and I thank Martin Capital for posting it.

CPI And The Rear View Mirror

It's very important to look out the windshield and not the rear view mirror when it comes to expected changes in the price of a representative basket of goods and services. More importantly, it is very important to pay close attention to attitudes changes about major purchases in that basket. That attitude change is massive. Never before in history have so many been willing to walk away from their homes.

A secular peak in consumption has been reached. We are now on the backside of Peak Credit. Those blindly paying attention to energy and food prices and little else are missing this vital analysis.

Now that energy prices have started to drop, year over year comparisons on the CPI are going to be very easy to beat. And by properly factoring in home prices, the CPI will likely be negative, perhaps hugely negative in the months ahead.

Real interest rates (using the suggested housing correction) will soon be soaring well above the long term averages as shown in the above chart.

Is there Justification For This Methodology?

For the record, I do not think it is possible to easily define and measure the prices of a representative basket of goods and services. However, the basket I presented makes more sense than the widely used CPI basket. It at least explains the so-called "irrational bond market" and it also accounts for the percentage of home ownership instead of attempting to figure out how much rent one would pay renting a house from oneself.

Problems Defining A Representative Basket

One problem with defining a basket of consumer goods is that such consumer baskets by definition ignore asset bubbles in the stock market and other places. For more discussion of this topic please see Inflation: What the heck is it?

Ignoring asset bubbles is what gets the Fed in deep trouble time and time again. The current CPI ignored the housing bubble on the way up and down. Is it any wonder the Fed is always chasing its tail?

And it is because the Fed ignores asset bubbles and because the Fed depends on a completely ill-formed measure of "inflation", that the Fed continually looks foolish when it comes to monetary policy. Inflation is after all a monetary phenomenon not a price phenomenon.

The solution to this mess is to eliminate the Fed and let the market set rates instead of letting the Fed micro-manage the economy to death.

Two More Measure Of High Real Interest Rates

There is still two more measure one can look at to determine whether or not real interest rates are high: Demand For Money, and Expected Return.

Demand For Money

There is a huge demand for money right now. Banks do not want to lend and consumers do not want to spend. Frugality Is The New Reality.

If we were in some massive inflationary period, people would be spending money as fast as they got their hands on it instead of saving it as noted in What's Behind The Soaring Savings Rate.

There are still many who have not figured out how massively deflationary crashing home prices are. Indeed, wild screams of hyperinflation still come from many corners in spite of the fact that there has never been a hyperinflation in history where housing prices crashed and the savings rate rose.

Housing prices are clearly crashing and the savings rates is indeed rising (the latter from a very low level).

In Austrian economic terms there has been a massive shift in "time preference". It is reflective of what one would expect if money could be put to better use later than now. Indeed the expectation is that home prices are going to fall, car prices are going to fall, and/or its simply better to wait.

Of course a case can be made that consumers are so tapped out they cannot spend if they want to, but the result will be the same: falling demand eventually means falling prices all other things being equal.

Return On Investment

The third measure of whether interest rates are high is in conjunction with what returns one might get by borrowing money. Outside of energy or production of some commodities, I cannot think of anything that is not in a massive state of over-capacity.

That overcapacity in conjunction with rising unemployment means that profits are going to be very difficult to come by. Indeed, there is no point to borrow money if expected returns are negative. Currently one cannot count on positive returns from the stock market, the corporate bond market, carry trades, housing, restaurants, nail salons, or even gold, silver, energy, and other commodities. Leverage is being forced out of the system at every turn.

Of course there are some Pollyannas who always think a massive recovery is just around the corners. However, banks are not acting as if a recovery is coming soon, nor is the treasury market, nor is the corporate bond market, nor are credit default swaps and various risk spreads.

Indeed the corporate bond market is acting as if it's Dead Banks Walking. And dead banks walking in my opinion is a continuation of the deflationary period we are in.

Three Measures Say The Same Thing

As measured by a "representative basket of goods and services", demand for money, or expected return on investment, real interest rates are reasonably high and about to get much higher! There simply is no bubble in treasuries.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

Recommended Links

Economist's View Why Do We Use Core Inflation

Consumer price index - Wikipedia, the free encyclopedia

Core inflation

Fiat currency

Hedonic regression

Household final consumption expenditure (HFCE)

GDP deflator

Inflation adjustment

Market basket (Basket of goods)

Substitution

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Last modified: September 03, 2008