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Inflation is Higher than CPI Says It Is and the Producer Price Index (PPI) Proves It

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?

Then there’s the biggest trick of all.

Home Prices Don’t Count, and That’s Bad News For Us

Assets don’t count at all, only consumption goods. So if housing is inflating at 6% a year, which it did for several years until 2018, it doesn’t count. That’s because houses are “assets,” not consumer goods. I’d argue that they’re wasting assets that are being consumed because they require regular expenditures to maintain, but the government says they’re assets. They don’t count.

Instead the government replaces home prices with rent. But it even manages to make that phony by ignoring market rent, which is rent as paid in current market transactions. Instead they ask tenants how much rent they are currently paying. It doesn’t matter if they just rented the place or have been there for years with a lease with nominal increases, or worse, rent controlled.

Therefore the way the government surveys rent for CPI bears no resemblance to the actual inflation rate of housing. The government imputes housing inflation at the reported rate of increase of contract rent. That counts for nearly 40% of core CPI. It has meant that through the years, CPI has understated inflation by around 1 percentage point and sometimes more. This is particulary true since house prices began to recover in 2012.

CPI Owners Equivalent Rent and FHFA House Price Index

So we know, right off the bat, that inflation is running a lot hotter than the government reports. How hot is it?  I like to look at several alternative measures that don’t manipulate the numbers. I have also developed an adjusted CPI that includes housing at its actual inflation rate.

Here’s How Hot CPI Really Is

The Wall Street Journal headlined with “Inflation Cooled in February.”  It said that “Inflation cooled slightly for American consumers last month, keeping the Federal Reserve on track to raise short-term interest rates next week, but relieving it of pressure to take more dramatic action to prevent the economy from overheating.”

I’m not sure why the Journal would jawbone the Fed to do a rate increase this month when the stock market has been betting against it. But that’s what they did. took a different approach. It said that “U.S. consumer prices rose for the first time in four months in February, but the pace of the increase was modest, resulting in the smallest annual gain in nearly 2-1/2 years.” So their approach was that inflation is the weakest it has been since 2016. 

True, but it seems to me that they’re doing just a little hair splitting. In fact, this may be the bottom of the trend.

And that trend has been remarkably consistent since 2012, when the Fed announced its 2% inflation target.

CPI Not seasonally Adjusted

But the Outlook Isn’t Benign – The Fed is Behind The Curve

Here’s the problem. The published rate understates the reality.

Here’s a chart showing Core CPI versus a measure of producer prices of finished consumer goods ready for retail sale, excluding food and energy. What’s wrong with this picture? The wholesale prices of core finished consumer goods are rising at 2.75%, and have been consistently a half point higher than CPI for nearly 2 years. Not only that, but their inflation rate has been in a rising trend since mid 2016.

Core Finished Consumer Goods PPI and Core CPI

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.

Wage Inflation, Core CPI, and Fed Funds

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.

CPI Vs. Adjusted CPI Including Housing

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.

Therefore, it would not be a good idea to chase this market. But we can look for trading profits with puts and calls on the stock market. We can deploy just a small amount of risk capital to limit risk while taking advantage of the leverage. I make weekly recommendations on puts and calls on the SPY in the Technical Trader reports at Lee Adler’s Liquidity Trader. Try the service for 90 days, risk free!

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Lee Adler

I’ve been publishing The Wall Street Examiner and its predecessor since October 2000. I also publish, and was lead analyst for Sure Money Investor. I developed David Stockman's Contra Corner for Mr. Stockman. I’ve had a wide variety of finance related jobs since 1972, including a stint on Wall Street in both analytical and sales capacities. Prior to starting the Wall Street Examiner I worked as a commercial real estate appraiser in Florida for 15 years. I also worked in the residential mortgage and real estate businesses in parts of the 1970s and 80s. I have been charting stocks and markets and doing analytical work since I was a teenager. My perspective is not of the Ivory Tower. It is from having my boots on the ground and in the trenches of the industries that I analyze and write about today.