Why the Fed's Core Inflation Method Is Not an Accurate Indicator

|
Includes: CAJ, DJP
by: The Intermarket Edge

The core inflation method used by the Fed is not an accurate reflection of inflation, nor an 'indicator' in any sense of the word. It is a backward looking, 'lagging' indicator. To get a grip on how the pressures of global inflation are building, one must look beyond labour costs and start considering the very real nature of rising prices in raw materials.

The CPI calculations have been changed so much over the last 30 years that most retail traders may not even know what it measures anymore.

Click to enlarge

click to enlarge

One can only wonder why such grand differences exist. The largest component of the CPI is housing, right? The biggest change in the CPI was made in 1983. During this time, CPI methods changed and stopped using housing prices as the main component, switching instead to the subtle 'owners equivalent rent'. This new method is described as "the amount of rent that could be paid to substitute a currently owned house for an equivalent rental property".

The very composition of the CPI does little to actually give you a fair representation of the 'rising cost of goods'.

By the way, even the 'beverage' portion is limited to alcoholic beverages. Think of all the soft drinks being consumed in the US that are not factored into this calculation. A bit of common sense tells you that if you get paid a certain amount per annum, drive to work, eat food and drink beverages, the difference that you utilize for other costs of living are affected. Your groceries and college tuition fees are getting higher and higher and obviously this filters down to how much you are willing to dish out for 'owners equivalent rent'.

So if you're like me and the present measures don't really make much sense when applied in the real world, then what is a better way to start structuring an approach that allows you to pick up on inflation ahead of the crowd?

There are several methods you could use, but they will most likely revolve around trying to discern where the majority of the flow-of-funds are moving and the movements of the prices of raw materials in multi-currency terms.

This is the CRB in Yen terms:
Click to enlarge

This is the weekly chart of commodities without the inclusion of energy:

Click to enlarge

Watch these charts very carefully over the coming months as the yen begins to depreciate and Japanese demand for metals and other raw materials increases. Notice how these trends have broken the 50 day moving average and are just about to breach the 200 moving average. The CRB has already breached these levels in US dollar terms, Australian dollars, and even in Euro terms.

I don't believe that over the coming months Japan will be an exception in this case as they rely heavily on imports, and are receiving trillions of yen stimulus to boost their exports. If global inflation becomes a reality, then it may become a condition that is sustained over several years, as Central Banks are unable to contain it with parabolic movements in interest rates.

This crisis implies opportunity.
Click to enlarge

If you're in it for the long haul, I believe Canon (NYSE:CAJ), being a major exporter with basically 'zero debt', is one investment worth buying up, as well as Honda (NYSE:HMC).

I believe those who manage risk well and take the whip-saws, will do extremely well come next year. Those in fixed income however, may be caught off guard if this view proves true. If rates are not hiked sufficiently soon then it is already too late for some and will be devastating to those who waited for "real core inflation" to show up.

Disclosure: I am long TMV, CAJ.