The Unpleasant Truth About Inflation
By Barry Ritholtz
RealMoney.com Contributor
10/23/2005 10:27 AM EDT
As recent debate on the pages of this Web site has shown, there is a divergence of inflation views. There's plenty of misinformation and spin out there, too.
I believe the economy is experiencing robust inflation, and has been for some time. While energy certainly is a part of that -- crude oil has run from $25 to as high as $70 -- inflation is not just confined to energy.
What Is Inflation?
Inflation is the rate of increase in general prices of all goods and services. It also can be described as a decrease in the purchasing power of money.
Regardless of your definition, inflation occurs when goods and services cost you more than they did previously. As this happens, your money becomes worth less than before.
How Is Inflation Measured?
The Bureau of Labor Statistics uses a basket of goods and services to measure inflation from both the consumer (CPI) and producer (PPI) perspectives. The basket includes: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services, including tobacco, haircuts and other personal services.
I have been critical of the way this basket is constructed and measured. First, it does not adequately reflect how people in the real world experience price increases. Second, permutations, substitutions and hedonic adjustments further distance CPI from the real world. In several categories, the BLS massages the data beyond any correlation to reality.
Torture data long enough, and it will confess to anything you want it to.
The So-Called Core
Speaking of torture, the CPI core is a measure of inflation with food and energy removed. By taking out the more volatile elements, economists ostensibly avoid having a single outlying month disrupt an orderly data series.
More numerically literate observers might think a simple moving average would do the same thing. It would reveal when prices are rising, while smoothing the impact of one-time price spikes. Yet this is not how most economists report CPI. One has to wonder why they have been reporting inflation data excluding energy 48 months into a robust move upward in oil prices. That hardly looks like removing a one-time "outlier."
The CPI ex energy measure is misleading, as it makes inflation appear far more benign than it really is. But don't think it's just energy; lots of other items have also risen in price.
The CRB Index, for example, has been in a strong uptrend since October 2001. Yet despite all these rising prices, the core CPI rate has remained remarkably stable.
In addition to energy and other commodities, education expenses have outpaced median inflation, as have health care costs.
But the biggest factor not reflected in the CPI basket is the cost of housing. Home prices have gone up dramatically -- the National Association of Realtors' Housing Affordability Index is now at 14-year lows. But you cannot tell that from the CPI.
Doctoring the Data
While commodities and education are being undercounted, housing actually lowers inflation readings. Tony Crescenzi addressed this relationship earlier this year in an article called "How Housing's Surge Is Suppressing CPI."
The way BLS accounts for housing expenses is an oddity that creates all sorts of problems. Before 1983, CPI measured housing inflation by looking at what it actually cost to own a home: house prices, mortgage rates, property taxes, even maintenance. After 1983, BLS changed the housing component, using the concept of "owner's equivalent rent." It's a measure of what homeowners could get for their homes if they rented them. It accounts for 23% of the overall CPI and about 30% of core prices, according to BLS.
Since the housing market began soaring, rental properties have languished. Vacancy rates rose, and rents came down in price. This had the surreal effect of pushing CPI measures down. At exactly the time housing became extremely expensive, the BLS measure of this component made inflation appear to be going lower.
What happens to the CPI inflation if we back out this absurdity? Tim Iacono, host of the blog The Mess That Greenspan Made, did the number crunching. As the chart below shows, if we revert back to the pre-1983 measure of housing costs, the core CPI spikes to a more realistic 5.3%.
Click here for larger image.
The CPI's miscalculation is even worse than you might imagine. As utility costs go up, inflation is further under-reported in the CPI (core or headline). Why? BLS perversely removes the value of any landlord-provide utilities in its calculation of owner's equivalent rent.
And you wondered why I mock the Labor Department's statistical methodology. Talk about adding insult to injury.
What Makes Inflation So Bad?
The impact of inflation is clearly negative on the broader economy. It hurts the credibility of the Federal Reserve, whose primary goals include price stability; undermines the dollar's buying power and appeal to foreigners (as a debtor nation, we don't want that); and provides yet another disincentive for Americans to save because cash loses its value over time when inflation is ascendant.
Inflation is also a problem because various federal programs (including Social Security, Veterans Benefits, Medicaid) have cost-of-living adjustments built into them. As inflation -- as measured by CPI -- goes higher, the payments increase, putting an increasing burden on the federal deficit.
But inflation's effect on corporate profitability and equities is particularly pernicious.
Inflation Raises Corporate Borrowing Costs: As these expenses increase, the extra price paid to borrow comes right off of the bottom line.
Inflation Squeezes Margins: As producer prices go up, companies often have the Hobson's choice of either raising prices -- and risk losing sales -- or eating the higher costs. If they cannot pass thru wholesale price increases, margins get squeezed, hurting earnings.
Competition for Capital: As rates rise, bonds become increasingly more attractive. Better yields, no-risk, tax-free Treasuries pull money away from the stock market; this is one of the biggest dangers to equity investors. Watch the flow of funds away from equity mutual funds. Ultimately, this can lead to lower prices.
Recessions: Inflation causes the Fed to tighten, and often at the same time, rising energy prices crimp consumers. A recent study by Merrill Lynch's David Rosenberg noted that when the Fed tightens and oil prices rise, GDP typically contracts. When all three factors coincide, that does not bode well for the macro economy and equities.
Conclusion
It is crucial for investors to have a realistic understanding of how robust inflation is. Doing so early reveals investment opportunities that those who focus on the core CPI have missed. In particular, oil, commodities and gold have been attractive investments overlooked by the "no inflation" crowd.
Now, as the Fed rate tightening cycle goes from being accommodative to neutral and beyond, the risk to domestic equity holders increases. I have been advising clients that as we come to the end of 2005, they should be getting increasingly defensive. In addition to owning gold, they should be looking to increase their exposure overseas.
Those who live in a synthetic reality -- seasonally adjusted, hedonically altered -- will confront the unpleasant reality of the real universe. Ignoring inflationary data in the CPI won't make it go away. All that accomplishes is to shift the focus away from precisely where it should be: on the part of CPI that has been rapidly increasing in price.
Those who fail to grasp this will pay a heavy price for their self-imposed ignorance.
