A Tale of 2 Inflation Rates

by: Barry Ritholtz

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 . . .



Consumer Price Index Summary (PDF version)
BLS, Friday, June 15, 2007

Food, energy costs' exclusion debated
Barbara Hagenbaugh
USA TODAY, June 14, 2007

LowRisk Investor Sentiment at Extreme Bearishness
Traders Narrative, June 14th, 2007

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