Real Inflation Measurement: The Core/CPI Spread

As we have previously discussed, inflation remains contained to the rest of the world ex-USA. Globalization be damned, there may be rapid price rises in most of the world, but there is no inflation in the U.S., thanks to a combination of hedonic adjustments and the absurd focus on the core rate.

Whenever I hear the phrase "excluding volatile food and energy" I just laugh. Can a pricing group be considered volatile if it merely goes up each month in an orderly fashion -- for years and years?

That's not volatility, thats a trend.

One way to actually measure how absurd the US core inflation measure is to look at what has happened to the spread between headline CPI and Core CPI. If Core CPI is understating inflation, than the spread should be widening. If it is accurate, the overall ratio between the two should be relatively steady.

What does the data show? The spread has increased substantially since the US adopted an ultra low rate/easy money policy under Greenspan (now affiliated with bond giant PIMCO). Since the easy money policy of the 1990s, and the rate slashing of the 2000s, it is no coincidence that the spread between the headline number and the core has grown dramatically.

If you want to trace this widening spread back to its origins, it coincides with implementation of Boskin Commission changes in CPI. (About as intellectually dishonest analysis of Inflation as has ever been penned -- its goal was to reduce Social Security payments and avoid bankrupting the US Treasury -- not measure inflation accurately). Since then, the spread between the core and headline data have only grown further apart.

This simply reflects the government's BLS inflation data diverging from reality.

Core CPI flatlined over the past 8 years because that is how it was constructed -- to not show inflation. However, the absurdity of the adjustments in inflation measures is revealed in the widening spread between Core and Headline: [click to enlarge]

CPI minus Core CPI (1980 to present)

Notice how tightly the two data series coincide (top chart) in the latter half of the 1980s and all of the 1990s? See how that starts diverging in 2001?

Bill King points out: "Targeted inflation may be the headline CPI, or a derived core inflation measure. In either case central banks should be aware of the sources of error and bias in their country’s CPI"

If you really want to econo-geek out on this stuff, there are several good resources for taking apart how this data is constructed:

Core Inflation Measures and Statistical Issues in Choosing Among Them
Mick Silver
IMF Working Paper April 2006

PCE Inflation and Core Inflation
Julie K. Smith
July 6, 2006

Comments

[Johnny Bitc...:]

Barry -

I don't suppose it's much of a stretch to believe that government statistics are biased by design and/or incompetence.

But what is your main point, here ?

Is it that inflation is higher than government statistics are reporting, and the reasons are a combination of

1) seeking to reduce government cpi-adjusted liabilities,

2) seeking to deceive the public into believing that the money supply is being managed responsibly, and

3) incompetence or insufficient effort to be intellectually honest

If so, I can generally agree.

But, let's take it a step further, shall we ?

What is the relevance to investors and/or U.S citizens ?

1. Surely investors can see through bogus government statistics and are apt to make their own estimates, no ?

2. Do you have a specific asset class that you believe is inefficiently priced based on bogus government statistics ?

3. Are you worried that your Long Island mortgage payment is in future default jeopardy as you begin to rely more on Social Security payments and less on getting paid to not make bad forecasts for clients ? or make bad forecasts ? or make lucky forecasts ? or whatever it is that clients are paying you for ?

Anyway, notwithstanding my efforts to rattle your cage for amusement, and in hopes of getting you closer to the path of enlightenment........I do agree with much of your general economic perspective.

However, the challenge, as we all know is whether perspective can be converted to alpha.

In the absence of carrying your theories into some kind of cohesive investment thesis, it seems like chit-chat.

And if one were to try to interpret your confused investment philosophy at your website, one might reasonably conclude that you believe in efficient markets........well, you have to ignore some of the internal inconsistencies and try to establish which contradictory statement you believe more strongly........but I am going to go out on a limb and say that you generally believe in efficient markets.

If this is true, why don't you do the following:

1. Tell your clients that you are not earning your fee

2. Convert everybody to a diversified index fund or ETF

3. Dump your Long Island mortgage

4. Teach 3rd Grade math to the underpriveleged

Just a thought, Barry.

John.

2007 May 16 04:00 PM

[brynaw:]

@johnrightwing,

<i>1. Surely investors can see through bogus government statistics and are apt to make their own estimates, no ?</i>

Based on most U.S. households financial situation (negative national savings rate, chronic inability to control spending), and a sizeable 34% cannot even identify the type of mortgage they have (www.bankrate.com/brm/n...), I would say that's a resounding "no".

<i>2. Do you have a specific asset class that you believe is inefficiently priced based on bogus government statistics ?</i>

I doubt the private financial markets even bother to pay attention to CPI statrickery anymore. They probably watch the PPI or generate their own (more reliable) numbers. OTH, people living on fixed-income programs that are directly tied to the CPI are probably hurting.

<i>3. Are you worried that your Long Island mortgage payment is in future default jeopardy as you begin to rely more on Social Security payments and less on getting paid to not make bad forecasts for clients ? or make bad forecasts ? or make lucky forecasts ? or whatever it is that clients are paying you for ?</i>

My, my, we're getting awfully personal and touchy here, aren't we? Ad hominem attacks are a sure sign that someone's "hot button" got pushed. You work for the BLS by chance? ;-)

2007 May 16 08:31 PM

[ritholtz:]

I do not believe markets are, (At leats as has been classically described) particularly efficient.

At best, they are kinda-eventually-sorta... Efficient bigpicture.typepad.com...

The frequently are Hardly Efficient
bigpicture.typepad.com...

And there are times when they are Astonishingly Inefficient bigpicture.typepad.com...

2007 May 16 09:35 PM

[ritholtz:]

Incidentally, those were amongst the first 5 hits when I went to The Big Picture and searched for "Efficient Markets."

Let me know when I can swing by to chew your food for you . . .

2007 May 16 09:38 PM

[fkhanmd:]

What's "BLS" ?

2007 May 16 10:52 PM

[brynaw:]

BLS = U.S. Bureau of Labor and Statistics (the people that publish the CPI, PPI &amp; unemployment numbers).

2007 May 17 02:44 PM

[Johnny Bitc...:]

OK, Barry, so let's try to synthesize your confused utterings with respect to this new information:

1. You['re not very good] at forecasting (as described in your investment philosophy at your website)

2. You don't believe markets are particularly efficient (as described above)

Now, this would appear to leave you in a bit of a predicament as far as career opportunities in investment management goes.

I would think that [<em>edited for language</em>] forecasters like you would be in a better situation if markets were efficient. Then you could just guide your clients into passive strategies and whack 'em for a small fee for your wise understanding of the situation.

Inefficient markets, on the other hand, leave [<em>edited for language</em>] forecasters in an uncomfortable situation.......and maybe that's why your [responses] are so inconsistent.

Don't strain yourself in googling your past utterings, and please don't develop the false impression that one's importance in the world is somehow related to [the work] one has been able to accumulate in cyberspace. <em> [edited for language]</em>

On the other hand, maybe that's where you found your previous utterings.

No doubt they originated there as well.

No disrespect intended,

John

2007 May 16 11:20 PM

[Ryan Wall:]

It is clear that John is either an investment Guru or that he simply doesn't care. There is a lot more that could be said but I don't like to watch myself type.

2007 May 17 01:24 AM