Easy Money (2): U.S. Inflation Now at 4% - How Fed Dismisses the Signs

by: John Tobey, CFA

In "Easy Money (1): Fed Touts Flawed/Risky Rationale," we discussed the Federal Reserve Open Market Committee's (FOMC's) weak rationale for easy money.

Today, we'll cover how the FOMC dismisses clear signs of 4% inflation.

As FOMC members speak out, trying to deflate growing inflation worries, they are revealing weaknesses in their analysis. Judging by their comments, they are using selected data to support their arguments and dismissing other, better signs of inflation.

There are two important problem areas:

First, the FOMC's preferred price index adjustment (i.e., excluding food and energy) is misleading. It is resulting in significantly reduced price inflation readings in this economy.

Second, the official money supply numbers are too low. The FOMC's policies are creating the problem.

Today's write-up addresses the Fed's choice of an inflation measure. Money supply will be discussed in the following write-up.


To measure inflation, the FOMC prefers the Personal Consumption Expenditures Price Index (PCEPI) to the Consumer Price Index ((NYSEARCA:CPI)).

The PCEPI has a unique construction that makes it less effective than the CPI in measuring price inflation caused by money supply expansion. The problem is that it expands the parties involved beyond consumers and it allows the spending basket to continually change. These moving parts can disguise what we're looking for: fiat money inflation

Even at that, the two indexes are highly correlated, with the PCEPI being a bit less volatile. (And the FOMC likes less volatility, as will be discussed next.)

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In addition, here is the comparison of CPI and PCEPI excluding food and energy (to be discussed next).

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Note: For the rest of this write-up, I will be using CPI data because of the high correlation between CPI and PCEPI, CPI's better measurement of inflation and the availability of CPI component data.

Excluding food and energy is improper

The Fed and others defend taking food and energy out of a price index because they are so "volatile." Supporting this proposition is usually a graph like the following, showing 12-month price changes comparing with and without.

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That graph may look like the only effect is volatility, but it's not. Food and energy have their own price trends beyond those movements.

Importantly, food and energy, as key commodities, are at the heart of all long-term inflation studies. When inflation shows up, food and energy prices are among the first to react. They are even better measures today because these worldwide commodities can be both traded and transported among countries with relative ease. (Contrast food and energy price moves to other CPI categories such as housing, medical and education. These other items react slowly to inflation caused by money supply changes.)

Looking at the cumulative price movements, not a simple 12-month moving one, we can see a significant rise in inflation by including food and energy.

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Clearly, there has been more inflation in the U.S. than the Fed's measure is showing. The 11+ year 2.5% inflation rate is well above the Fed's "limit" of 2%.

Housing, the FOMC's inflation friend, should be excluded

Housing costs are slow moving and significantly affected by factors beyond money supply inflation. These characteristics are visible in the CPI-housing index.

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Note especially how the housing price index changed its shape in the past three years, during which housing costs were down or flat. As we know, this pattern reflects housing's supply/demand conditions – not the effect of the FOMC's easy money policy. Therefore, including housing in the price index hides what's actually happening.

All countries face the same problem. Therefore, a common CPI adjustment made outside the U.S. is to report CPI excluding housing. Such an adjusted index is thought to be a better measure of price inflation.

The preferred inflation measure: CPI excluding housing

So, let's adopt the international convention and examine CPI without housing. Although it is not a publicly released CPI number, we can approximate it.

Housing represents about 40% of the CPI basket (much higher if food and energy are excluded). By presuming a 40% weighting throughout the period (this isn't precise, but it is an acceptable approximation), we can use the CPI measures available to calculate:

CPI excluding housing = [(CPI * 100%) – (CPI for housing * 40%)] / 60%

Here is the result:

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Comparing the price index numbers

Now let's compare all those different measures. Here are the different price index results for the entire period and sub periods.

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Note how many readings show inflation above the Fed's "limit" of 2%. The latest ones are the what's bothering investors - especially as the FOMC takes comfort in its single, low measure.

Final thought: Why only one index?

Looking at these different index results raises the question of why the FOMC publicly uses only one number to defend its easy money policy. Is it playing the old marketing game of cherry picking the statistic that best supports its position? Or is it myopic, focusing on its one choice, believing all other measures to be flawed and, therefore, not requiring presentation or explanation? Or is it simply trying to keep our confidence up and not adversely affect "inflation expectations?"

Good analysis is fulsome (looking at an issue from all sides), objective (not being influenced by other considerations) and unique (incorporating underlying conditions, not simply relying on a number). The FOMC's comments have not shown good analysis – and that is worrisome.

So … price index measures are showing inflation running well above the FOMC's 2% "limit." These measures lend support to the rising inflation concerns we read about, along with rising long-term interest rates (in spite of the FOMC's bond buying program). Only the FOMC seems relaxed - and that's causing even more concern.

Next … reported money supply numbers are too low.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Client positions: Long U.S. stocks and U.S. stock funds. No bonds held.

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