E-piphany

The CPI release right now is like a coded message…or perhaps a better analogy is George Orwell’s Animal Farm. You can read the report on two levels: on one level, it’s an interesting little story. In the case of CPI, the pleasant story is that inflation remains low and tame, with core CPI printing 1.7% year-on-year, right in the middle of the Fed’s comfort zone and enough off the lows that deflation fears can be quelled.

But of course in Animal Farm there is a deeper meaning, and so too must we dig a little deeper into the CPI report these days. The reason there is some necessary digging is that a large portion of CPI (and especially core CPI) is Shelter: rents, owner’s equivalent rent, and lodging away from home (hotels). Ordinarily, this is a pretty stable part of the series, especially since 1983 when the Bureau of Labor Statistics (BLS) adopted a “rental equivalence method” to evaluate the cost of living in a home.

But right now, we are coming off a bubble and the deflating price of housing is weighing down overall inflation. Thus, if we want to get a true picture of how the prices of goods are responding to the extraordinary global monetary stimulus, we need to abstract from the Shelter component. We need to look at CPI ex-Shelter.

This is no mean feat, because the BLS doesn’t calculate CPI ex-Shelter. We need to do it ourselves.

When you do that, you get a fascinating story. What we see (Chart, source Enduring Investments and used with permission) is that Core CPI ex-Shelter is rising and has been rising quite steadily for some time. Core CPI ex-Shelter rose 2.756% over the last 12 months, the highest rate since November 1995; over the last 6 months the pace has been 2.92% and over the last 3 months, 3.30%.

Which line do you think the government wants you to focus on?

To me, that chart looks like a very important bottom was established in 2003, and inflation has been accelerating ever since in fits and starts. And it looks as if there’s a chance it might be “breaking out,” to go all technical on ya’.

In the latest month, Shelter fell a seasonally-adjusted -0.224%, the largest single-month decline since the BLS adopted the rental equivalence method in 1983. And that’s what held down, continues to hold down, core CPI.

On which series should the Fed focus? The Fed is clearly trying to dampen the disaster in housing, and perhaps has succeeded. But the cost is becoming clear: most of the economy is inflating, 10% unemployment or not.

Interestingly, this same chart helps take some of the blame off the Fed for causing the housing bubble. Ex-housing, prices really were close to deflation in 2003. If most of the economy was nearly deflating, then the Fed’s aggressive easing back then may have been appropriate – and the bubble, which was already underway, may be more due to changes in incentives/bullying proffered by Congress to the GSEs (Fannie and Freddie) and other things. I’m not an apologist for the Fed, and it was probably pure luck, but Greenspan may have been concerned about deflation for a good reason.