A Tale of 2 Inflation Rates

Friday morning's inflation rate was terrific. Or terrible. What you saw depended upon where you looked.

Wall Street looked at the core rate, which came in at 0.1% (actually 0.149%, but that gets rounded to one decimal place -- hence, 0.1%).

Futures blasted off on that number, but as my colleague Bill King mentioned Thursday night, it's a quadruple witch option expiration day, you needed a pretty awful number to derail the expected expiry moon launch.

There can be little doubt that consumer inflation -- up 2.7% year-over-year -- is slowing with the economy. The core CPI remains elevated at 2.2% year-over-year -- slightly above the Fed's comfort zone of 2.0%.

Credit for the lowered core rate goes primarily to Owners' Equivalent Rent [OER], which rose a scant 0.1%. Housing is 42% of the the CPI (33% of the core), with the Owner's Equivalent Rent 24% of CPI, and over 30% of the core rate. Did housing prices suddenly get much cheaper? There's little evidence of that. So far, the ongoing slide in prices is relatively measured -- orderly, even. And we saw that mortgage rates ticked up significantly over the past month, which further pressures home prices. Of course, utilities -- excluded from OER -- are ever higher (ironically, we came across this headline Friday morning: Heating bill delinquencies jump -- and it's now well past heating season).

So how did OER moderate so much? My guess: Excess supply. All of those condos, purchased pre-built, all of the speculators who couldn't find a chair when the music stopped, and those oh-so clever home flippers -- these folks have become involuntary landlords. En masse, they are renting these properties; that huge surge of supply is keeping rental prices down.

Meanwhile, BLS reports that Energy prices are up 71% on an annualized basis in the past 3 months (Compound annual rate 3-mos. ended May '07).  The headline number for CPI was the biggest since the Katrina impact (1.2%) in September 2005. Indeed, you have to go back to April 1999 to find a
higher headline number sans weather disaster.

At the same time, the core CPI has grown at a 1.6% annualized rate over the same three month period.

This discrepancy has led to the media finally acknowledging the absurdity of inflation ex-inflation. An article in Thursday's USA Today (of all places) noted:

"When it comes to measuring inflation, consumers and economists often don't speak the same language.

When consumers think of inflation, they often focus on prices of things they buy regularly, such as food and gasoline, which have been going up significantly in price this year.

But when economists, including Federal Reserve officials, talk about inflation, they often focus on a measurement of price pressures called "core" inflation. Core inflation excludes costs of food and energy goods, the very items that are the most visible prices for most consumers. Many economists will be focusing on the core when the government releases its monthly producer price index today and the closely watched consumer price index Friday."

The risk of focusing on the core is that Fed risks losing credibility in the eyes of the public. Future inflation expectations are not nearly as muted as the Fed's benign core rate.

Of course, none of this should matter to traders. The momentum remains strong, and the overall psychology still disbelieves the market. In fact, a few recent sentiment measures are so bearish that it's all but impossible for a top to form here (I'll go into some details on this later).

The melt up to Dow 14,000 continues . . .

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Sources:
Consumer Price Index Summary (PDF version)
CONSUMER PRICE INDEX:  MAY 2007
BLS, Friday, June 15, 2007
http://www.bls.gov/news.release/cpi.nr0.htm

Food, energy costs' exclusion debated
Barbara Hagenbaugh
USA TODAY, June 14, 2007
http://www.usatoday.com/money/economy/inflation/2007-06-13-inflation-usat_N.htm

LowRisk Investor Sentiment at Extreme Bearishness
Traders Narrative, June 14th, 2007
http://www.tradersnarrative.com/lowrisk-investor-sentiment-at-extreme-bearishness-1066.html

Comments

[jr7107:]

Excellent commentary. I have never understood why they exclude the "core" food and energy. We all buy it. We all need it. A consumer's primary expense will likely have one of these in the top 5 monthly. I feel inflation, but the market does not. Melt up 14,000? Sure, whatever.

2007 Jun 17 12:35 AM

[Johnny Bitc...:]

Ridiculous commentary.

Both the core and the headline number are well publicized and the market participants that count fully understand the difference.

Ritholtz claims to know what the market paid attention to (in his confused mind it was the core number).

In reality, the market pays attention to both numbers.

Basically as long as energy price inflation does not flow through to consumer goods, many market participants conclude that inflation is under control. Whether this is right or wrong can be argued, but Ritholtz silly claim that he's the guy that noticed headline inflation, but the market only noticed core inflation, is simply ludicrous.

And ya gotta love this guy prattling on about the "media". I think a guy that blows smoke out his ass on CNBC can fairly be called part of the media.

Guess what, Barry: You are the media and USA Today journalism has not cornered the market on incompetence and economic chit-chat.

Regards,

John (not part of the media)

2007 Jun 17 03:24 AM

[wixeywaxy:]

John your vulgarity fits very well with your vindicative and vacuous message. A respectable person would be embarrased to punctuate their remarks with this kind of language in print. Your opinions could be stated without insulting remarks and if you had a measure of intelligence you might realize that they too are just that opinions. Vic

2007 Jun 17 11:07 AM

[wixeywaxy:]

Mr. Ritholtz I find your articles interesting and appreciate your willingness to challenge the spin put on the inflation measurements. The importance put on falling housing prices is not appropriate. Only a very small percentage of consumers are at any one time entering or exiting the real estate market. I have lived in the same home for many years as have most of my neighbors. Housing cost are not inconsequental but it's the related expenses of home ownership, taxes, insurance, and maintenace that effect most people and from my own experience I can tell you the inflation indexes are not reporting the increases in these at anywhere close to the facts. Vic

2007 Jun 17 11:19 AM

[Katy Delay:]

I like the article. I also think it is important to point out to readers that the word "inflation" is confusing because it's used by many people--laypersons and economic academicians alike--to mean one or both of two distinct phenomena: (1) price increases, no matter what the cause; and (2) general or specific price increases caused by an excess of purchasing media.

The public is concerned with (1). The Federal Reserve board members are concerned with both (1) and (2), but mainly with (2), because they believe they control the supply of purchasing media and prefer core numbers because these do not include price increases caused by factors outside the Fed's "control." (Whether their efforts to control the money supply are efficacious or deleterious is a discussion for another day.)

The market is concerned with both, because players are in the business of making money, which business depends on what both the public and the Fed board members do.

Economists would do well to invent another word for either (1) or (2) so as to be more clear. Their semantic slight-of-tongue makes one wonder just what their real intent is, i.e. whether it is to clarify or to confuse. Surely they know the difference... don't they?

2007 Jun 17 05:11 PM

[Paul Meisel:]

One other factor in the involuntary landlord business:

The long time it takes to sell a home has led to a big decline in the former practice of purchasing a house with the contingency "upon sale of my home"... sellers are not likely to take such offers seriously. Many buyers who are sufficiently capitalized then do a "wraparound", financing the new home while retaining the old home for sale and possibly renting at a discounted rate in between. Don't know often you see it but in my market it is common.

2007 Jun 18 09:56 AM

[Sonia Mirza:]

Paul - what market is that? East/West?

2007 Jun 18 05:44 PM

[Paul Meisel:]

Northern Ohio -- west suburbs of Cleveland to Toledo suburbs......

2007 Jun 19 09:45 AM

[Sonia Mirza:]

Hmm...too far :)

it probably applies to our mkt here too - not my area of expertise but interesting to note

oh fantastic comment about the inverse relationship bet. vitriol/comments vs rigor/analysis!

2007 Jun 19 11:16 PM