Inflation: Pass It Through

The Federal Reserve has maintained a laissez-faire approach towards inflation, using the lack of “pass through” evidence as the basis in defending their position. After raising prices 20% last month, Dow Chemical (DOW) announced yesterday morning that it is increasing prices another 25% next month, and is instituting freight surcharges beginning in August. A survey of Chief Financial Officers released by Duke University last week* showed that nearly half of the CFOs surveyed intend to pass through higher commodity and energy costs their companies incur onto consumers. The CFOs expect prices for their products to rise by 4.1% over the next 12 months.

The Fed and their partners in the art of illusion over at the Bureau of Labor Statistics [BLS], have come up with some pretty creative ways over the years to mask the true rate of U.S. inflation. For readers interested in understanding more about what those methods are, I highly recommend Bill Gross’ June Investment Outlook.** Gross correctly asserts that if it wasn’t for statistical manipulation, the U.S. headline inflation rate would be inline with the global inflation rate which is currently 7%. The Fed and the government tries to brainwash us that we’re just so much more productive than other nations when the reality is that other countries take a straightforward approach in calculating inflation.

“Improving” inflation statistics has its roots in the Nixon administration with the debut of “core” inflation in the Consumer Price Index [CPI]. Core inflation removes “volatile” food and energy costs – the things we must consume on a regular basis. Just like the 1970s, there’s nothing “volatile” about food and energy costs that only go up. As if core inflation was not ridiculous enough, the Fed has a “preferred” gauge of inflation, Core PCE (Personal Consumption Expenditures).

Core-ing out inflation wasn’t cutting enough of it, so in January 1983 the BLS began Owner’s Equivalent Rent [OER]. OER comprises about 33% of the CPI. To quote the BLS:

It is Rental equivalence measures the change in the implicit rent, which is the amount a homeowner would pay to rent, or would earn from renting, his or her home in a competitive market.

 

OER is as real world ridiculous as core inflation. If you rent out your home, where do you live? Besides, a property has more value to an owner, both emotionally and economically, than it would be valued to a renter. This further makes the statistic ridiculous. Bill Gross describes OER asa dubious assumption belied by the experience of the past 10 years during which the average cost of homes has appreciated at 3x the annual pace of OER.

The 1990s brought three more manipulations – product substitution, geometric weighting, and hedonic quality adjustments. With product substitution and geometric weighting, the BLS automatically assumes that if one item increases in price, consumers will substitute a lower cost alternative (or at least use less of the original product). That means I make a recipe using half an egg and can somehow safely store the other half for future use. If I regularly eat apples, I’ll substitute cheaper oranges. Geometric weighting does not factor items that cost the same but weigh less because the manufacturer has decreased the product amount. It’s not “environmentally friendly packaging” that has suddenly shrunk that cereal box and laundry detergent!

Hedonic quality adjustments is a fancy term to trick consumers into thinking they’re getting more for less. The government will tell you that the price increase of a computer, TV, or car is not really a price increase because you’re getting improved and/or more features for that item. Again, the government is making the assumption that you want these extras/improvements. When manufacturers debut new models, the former more basic models are discontinued. The government likes to tout electronics as a deflationary indicator which helps control inflation, yet how many times per month do people buy a new computer, camera, TV, etc. versus gas and groceries?

Other conveniently overlooked aspects of the CPI are all the forms of taxes that consumers pay, insurance costs, home maintenance costs and association fees.

The CPI peaked at 13.7% in March 1980. If the Federal Reserve wishes to avoid a repeat performance, they will back up their recent speeches with monetary policy that makes it clear inflation is unacceptable. Otherwise, by May 2009 the US could break its previously held record.

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* The survey is part of a print edition article (“CEOs Predict Tough Times For Economy” by Kelly Evans) in the June 19, 2008 Wall Street Journal.

**Bill Gross is the founder of PIMCO, one of the largest specialty fixed income managers in the world. Former Fed Chairman Greenspan is a consultant to PIMCO. Gross frequently appears on CNBC and in the past has been a staunch advocate of a low Fed Funds rate. This is why his article was so surprising to me

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Disclosure: none

Comments

[Gigem77:]

Historically, gold has been the watchdog for inflation. The price of gold is up 36% year over year and nearly 400% since 2001. It puts the lie to the BLS nonsense. And this indicator is understated due to the Eurosystem banks dishoarding gold at the rate of 500 tonnes per year.

2008 Jun 25 05:49 AM

[tuj:]

Historically, currencies were tied to gold. Now, no major currency is. Gold has no major industrial or intrinsic value. Why wouldn't platinum, oil, or anything else with actual industrial or intrinsic value besides simple scarcity be a better indicator of inflation?

2008 Jun 25 10:37 AM

[JCCIII:]

Excellent article. If the anemic 2007-Qtr 4 and 2008-Qtr 1 growth rates are adjusted for the inflation rate argued in the article (7%), the US is in a recession. I hope the Fed is listening.

2008 Jun 25 10:43 AM

[CLH:]

Yes the fed. should raise interest rates or we will have inflation. Presently we have low inflation (not 7%).

2008 Jun 25 01:38 PM

[Jason Rines...:]

Who is the government attempting to kid? The 49% GDP of small businesses with no real outside help these days go to the grocery store and fuel stations and see it clearly. No need to argue recession there. The 30% GDP megacorpations have heard of a glorious new tool called the spreadsheet. 21% GDP government is probably the most misled (or at least they were). It's sickening. The country itself cannot even understand the scope of the true monumental sized problems, let alone accurately debate or come up with painful yet necessary corrections to avoid collapse. It drives you NUTS

2008 Jun 25 01:40 PM

[Reinko:]

Nice article.

To JCCIII:

Gross domestic product growth is already without inflation, that is why it is 'product growth'.

__________

For the rest it is laughable to observe they even use 'geometric weighting', this is nonsense!

But measuring inflation is a hard try, try it for yourself with only bread. Here in Holland cheap bread is 45 cents for 800 gramm, good qulity bread is around 95 cents to one Euro and luxery bread above two Euro.

How to measure changes in bread prices?

So you see: measuring inflation is difficult and depending on what your spending habits are, you have even an individual inflation number...

2008 Jun 25 01:46 PM

[jetsby10:]

tuj, first, Gold has great industrial applications. We don't use it because it's too valuable. I work in a lab and just had to order some gold plated lock washers because they have superior conductivity. The fact that we don't use it widely in the industry is one of it's strengths. The supply of physical shouldn't change that much year over year. Platinum has too many industrial applications so the supply can be greatly affected. If we used metals that have industrial uses to determine inflation we would have skewed numbers. If you looked at Rhodium, you would deduce we have an inflation rate of about 500% a year the past couple of years.

2008 Jun 25 02:18 PM

[semar:]

inflation will be one of the most important things in the next period, on the major markets, be it currencies, commodities or equities. It's something unacceptable to have a 0.2% real growth and inflation running at 4%.

2008 Jun 25 02:41 PM

[winslow:]

Politicians have learned how to fool people because the people buy into their thesis. It's an unending cirlce.

2008 Jun 25 04:02 PM

[mdmrjsds:]

Inflation is when prices rise because a currency is being debased. It is not about prices rising because of demand or supply shifts in a market. The commodity markets are experiencing huge price gains mostly because of demand increase, not a debasing of the currency, though the US dollar has been debased and is being debased to pay for our deficits. My guess would be that about 25% of the price increase is because of debased US$ and the rest is demand shift up the supply curve.

Gold is subject to inflation also. At the time the Spanish were plundering the new world, gold and silver were the currencies in Europe. The sudden influx of all the gold and silver from the new world caused massive inflation to occur. They debased the currency. Because the supply of gold has increased at a much slower rate than economic production, if we were on the gold standard we would be experiencing deflation. That's because a unit of gold would come to represent more and more production, so could buy more and more.

Inflation is very tempting to those who issue currency, as they get something for nothing. Politicians and debtors especially benefit from inflation.

2008 Jun 25 07:44 PM