A few months ago, I finally got to a topic that had been bugging me for a few years, and that’s how the CPI understated inflation the earlier part of this decade, and how it might be understating deflation now. Well, some academic researchers finally got around to discussing this same issue.
Barry Ritholtz points to this column in The Wall Street Journal. The column itself discusses a lot more than just the aberration caused by the CPI, such as why the loss in the real estate market is having such a devastating impact compared to the losses experienced during the bursting of the dot-com bubble, even though the losses in the dot-com burst may have exceeded the losses experienced in this current downturn. I have my theories on that:
- Back in 2006, with home ownership at an all-time high, more people perceived that their net worth was tied to real estate than to stocks, so the impact of the real estate decline was “felt” by more people. That hurt consumer sentiment, consequently hurting consumption more than the dot-com decline.
- Equity extraction in real estate drove consumption and, consequently, global economic growth. Now, the source for that equity extraction has disappeared, hurting the global economy. You didn’t have widespread equity extraction in the dot-com bubble. I mean, how many people do you know who were borrowing 110% of their stake in pets.com?
- In 2001-2002, there were places to hide. Even though stocks were getting clobbered, other assets held up. In this bear market, the correlation of everything went to 1. Even money market funds lost money. “Hedge” funds, which are supposedly hedged, got creamed. And those hedge funds that did make money … well, after Madoff and the long list of other Ponzi schemers out there, you’re left to wonder. That means there’s no place to hide.
- As alluded to in #2, there is much more leverage involved in real estate than in stocks. So the impact is magnified.
Bottom line, it’s pretty clear that the Fed was working with a flawed inflation model. What’s missing from the WSJ article, however, is that the same mistakes are being made now. As I noted back in January, the housing component of the CPI is showing house price INFLATION. That’s grossly wrong, and everybody knows it except the bureaucrats in Washington.