This is an update of our December 2018 inflation report.
When most of us think about inflation, we think of the prices of the things we buy regularly. The government supposedly measures that in the CPI – Consumer Price Index.
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I think that intuitively most of us experience a higher level of inflation than the CPI shows.
There’s a reason for that. The government doesn’t measure inflation, at least as classically defined. The classical definition is a rise in the “general” level of prices. That should include all things that are bought and sold – that have prices.
CPI Was Never Meant to Measure Inflation
The CPI doesn’t do that. It measures a narrowly defined, and statistically manipulated, basket of consumer goods and services. And the government does its best to suppress the inflation rate of those items. That’s because the CPI was never intended to measure a rise in the general level of prices. It was intended as a means for indexing the cost of labor contracts and government contracts in eras of high inflation.
Given that purpose, government statisticians have habitually looked for ways to get to these numbers to understate actual inflation. They use hedonics to substitute lower priced goods for higher priced goods when prices are rising because in theory consumers will make that switch. But if we wanted to measure general inflation accurately, wouldn’t we survey the prices of the same goods over time? If when prices are low you include steak, but when they’re high, you exclude it and include hamburger instead, how is that a consistent measure?
Contrary to the current conventional wisdom, this is not a benign inflation picture. It indicates that the Fed’s current target Fed Funds rate has been at a negative real rate, that is, interest rates are below the inflation rate until this month. That is, if you believe that the Core CPI is an accurate inflation measure.
As long as short term interest rates are below the inflation rate, rate increases will stimulate even more inflation, not suppress it. That will create a vicious cycle until rates become punitive, at a real rate high enough to slow consumption.
Now, while it looks like the Fed has caught up, the fact is that it is still running well below the wage inflation rate, and wage inflation is likely to push CPI up.
Furthermore, Core CPI does not measure general inflation, most glaringly because it fails to count housing inflation accurately.
CPI Including Actual House Prices Is Over 3%
Some years ago I developed an alternative CPI measure that replaced the phony rent component of CPI. I replaced the phony Owner’s Equivalent Rent measure with the FHFA house price index. This index shows that if housing were included in the CPI it would be rising at least 1 percentage point more than CPI. Because this measure includes food and energy, I’ve plotted it with headline CPI.
As energy prices have come down, this index has also come down. But it is still running 3.4%. I don’t pretend that this is a perfect inflation indicator. But in terms of measuring a comprehensive basket of items, it’s better for sure.
The adjusted index was only below the Fed’s target 2% inflation rate during the oil price collapse of 2014-15. But it has been back above that level since January 2016, and it has been persistently 3.5% or higher over the past two years.
I like the BLS PPI Finished Consumer Goods Measure, even though it does not include housing. At its current rate of 2.75% it remains above the Fed Funds target.
Sooner or later the headline CPI inflation rate will head back toward those higher levels in the next few months. I mean, how long can they ignore the reality?
Don’t answer that!
None of this even begins to approach the stupendous inflation of asset prices, which economists completely ignore, despite the fact that inflated asset bubbles eventually collapse and lead to financial system crashes.
This means that the more stock and bond prices rise in this environment, the greater the risk.
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