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Economics: Is Inflation Under Control?
New York: March 07, 2005
By John R. Stephenson

Some of the statistics that come out of Washington are truly amazing. Few statistics out of official Washington stretch credibility quite as much as the government's measure of inflation (rising prices) - the consumer price index ("CPI"). The official numbers suggest that prices across the nation are remaining stable and that inflation is being kept at bay. But does this make sense when house prices are soaring and crude oil has surged some 49% in the last year? It does, if you are a government economist.

The belief that inflation is under control and that interest rates will remain low for some time has allowed the consumption binge to continue unabated. The American consumer has taken advantage of low interest rates to gobble up an ever increasing array of consumer items by financing these purchases with home equity loans. In short, the U.S. consumers have turned their homes into ATMs. Not only do low inflation numbers out of Washington justify a low interest rate policy (with a corresponding boom in consumption) but they also conspire to keep wages down. But are the inflation numbers accurate?

Figure 1: U.S. Home Ownership Soars

Perhaps it is just a coincidence, but a low inflation number, which seem to fly in the face of common sense, is a huge benefit to the U.S. government. For starters, a low inflation number allows us to pretend that the dollar is stronger than it is, that stock markets will rally and that productivity is higher than it is. With inflation at bay and the economy running strong, the government can justify huge budget deficits and a monetary policy that allows it to hold real interest rates in negative territory for extended periods of time. Of course, this meets a desired end - a false confidence in the economy that encourages consumers to keep spending.

The mainstream media has lapped up the "official" numbers barely questioning the logic behind these ridiculous pronouncements. In the meantime, in an effort to save Wall Street and the stock market, the Federal Reserve has created a liquidity explosion by lowering interest rates to a ridiculous level. With all this easy money slopping around, the price of all asset classes, whether they are housing or stocks and bonds, has been driven up artificially. Although the costs of goods and services are clearly up, these higher priced goods continue to work their way into the economy unchallenged because of the shoddy way in which the government accounts for inflation.

So how is it that the official government view differs so much from our own experience? There appear to be three principal culprits that explain the difference between the government's calculations of inflationary pressures and the man in the street experience - hedonic adjustments, substitution and the housing component of CPI. By making these adjustments, the Bureau of Labor and Statistics is able to show that inflation is much lower than we would suspect.

In 1996, a special presidential commission determined that the government was reporting the cost of living "improperly" and therefore a new methodology for measuring inflation was introduced. Nowadays, some 56 percent of the components of the Consumer Price Index (CPI) are adjusted hedonically. Here's how it works. Say, for example, the cost in absolute dollar terms of a Lexus goes up, but according to the way that the Bureau of Labor and Statistics calculates, it can still be recorded at the old price level because the new Lexus is "more comfortable" than the old Lexus. If the price of gasoline on the open market rises by 23 percent, the Bureau of Labor and Statistics may only record this as 14 percent, if, according to their hedonic adjustments, the gasoline is "better" than the previous gasoline on the market.

Another way that the CPI number is understated is through the use of substitution. This is a maneuver that the Bureau of Labor and Statistics uses that assumes that if the price of a certain good were to rise, then the consumer would substitute that good with another cheaper product. If the price of a pound of beef rises, for example, the government assumes that the consumer would substitute a pound of chicken for the pound of beef (or some other lower cost substitute) and their figures could continue to show inflation under control.

Figure 2: Components of CPI

Source: Bureau of Labor and Statistics

The other way that the CPI number understates the true level of inflation in the economy is through the calculation of the housing component of CPI. The housing component of CPI is by far the biggest component (some 42%) of the overall index. Of that 42%, the biggest sub-component of the housing statistic used in the calculation of CPI is the Owners Equivalent Rent (55.7% of total). During 2004, the Owners Equivalent Rent showed an increase of some 2.2%. Yet, only 31 percent of the U.S. population was actually renting (figure 1). This, compares with a surge in house prices that dramatically altered the true cost of housing in the U.S. economy.

Figure 3: U.S. House Prices Soar

Source: U.S. Federal Reserve Flow of Funds Data

Governments around the world have a terrible track record of reporting "official" figures about the state of their economies and the U.S. government is no different. Unfortunately, no other government constructs their official figures with the same degree of conviction or magnitude as the U.S. government. The question is, why? For starters, the U.S. Federal Reserve (U.S. central bank) is charged with keeping both inflation low and the economy strong. Through the magic of substitution, Owners Equivalent Rent and Hedonic adjustments, the Federal Reserve is able to keep this dog hunting. By keeping the inflation number artificially low, the government can claim that inflation is under control and the economy is growing. In other words, if the level of the CPI (inflation) is really higher than what the government is stating, that means that the real economic activity or GDP is 1% less than reported.

The CPI number is also the key ingredient in the calculation of Social Security cost of living adjustments. Not only are Social Security payouts reduced with a low CPI number, but so too are military and civil service wage packages and the payouts to holders of TIPs (Treasury Inflation Protected securities). A more reasonable CPI number would cost the U.S. government a small fortune and would encourage the Federal Reserve to raise interest rates (to combat inflation), which might burst some of the financial, and real estate bubbles that have formed around the country from the government's easy money policies.

Investors would be well advised to avoid bonds or TIPs (Treasury Inflation Protected Securities) in an environment where interest rate rises look increasingly likely. As well, commodities, which are real things, offer an excellent hedge against the true inflation that is out there.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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