Inflation Reporting Errors, Continued

by: Barry Ritholtz

Wednesday, we looked at a way to measure actual Inflation: Comparing the "spread" between the Headline CPI data, and that of the Core CPI, we learn that BLS has been consistently under-reporting inflation over the past 8 years. Since then, we have come across two related discussions that shed additional light on the subject of accurate inflation reporting.

The first is via PIMco's Bill Gross. In his monthly commentary, Gross observes:

"A bigger threat to asset markets however, comes not from slower economic growth in the short-term, but inflationary pressures towards the end of our secular timeframe. Note first of all the increasing influence of non-core food and energy prices in G-7 nations over the past few years as illustrated in Chart 5 for the United States. Since 1967, average differences in headline vs. core inflation have essentially been zero, despite distinct periods of cyclical variation. Now, however, with globalization so dominant and Chinese/Asian appetites for oil, soybeans, and iron ore amongst other commodities so voracious, it’s hard to envision an extended period of lower headline U.S. increases. This may bias more central banks to begin considering headline numbers in their policy decisions like Japan and the ECB do already."

Gross is referring to the Core/Headline spread we referenced Wednesday. Wednesday's graph was a bit complicated, and the chart below makes it far easier to understand the changing relationship between the Core rate of CPI inflation, and the actual Headline CPI:


As you can see, since 2000 the Core has been under-stating inflation for some time now. And, the amount it is off by has widened dramatically. The gap between core and headline is now greater than it was in the early 1980s, and -- hard as it may be to imagine -- we are only slightly off the spread of the terrible 1970s.

But while we (and PIMCO) focus on the U.S. spread -- the BLS reported, Fed-focused deviation from reality -- others around the world have noticed the same "disconnect." A recent piece in FT by Wolfgang Munchau observed this same disconnect between inflation indices and what is experienced in the real world by consumers:

"The first time I ever began to doubt my country's cost of living index was in 2002 when euro banknotes and coins were introduced. In Germany, where I was living at the time, the prices charged by many hotels, restaurants and dry cleaners effectively doubled. If you spent a lot of time traveling, as I did at the time, the personal inflation shock was severe. I estimated my personal inflation rate in 2002 to be approximately 10 per cent. The central bankers were in denial because the official inflation index did not register any significant movements. It must have been in people's heads.

But this was nonsense. The problem was that the official inflation index no longer reflected many people's personal shopping basket. The index basket is full of manufactured goods largely produced in Asia, while we spend most of our money on services, such as childcare, education, healthcare, transportation, travel and gastronomy."

That very well sums up the U.S. experience. The basket of goods and services that is measured is so massaged and hedonically  adjusted, it manages to avoid inflation regardless.

Sometime ago on Kudlow, I debated the topic with Art Laffer (who believes there has been little inflation). But I disagree: The U.S. consumer is confronted with rapidly rising costs for food, energy, health care, housing, education expenses. Indeed, even as both the everyday survival expenses (shelter, food, energy) and the larger family expenses (Doctors, College, etc.) have exploded, there has been little correllation to what Economists and the BLS have informed them. Despite the contradiction, there is little inflation in the official stats. It is as if Economists are asking consumers "Who are you gonna believe, us, or your lying eyes?"

Munchau notes that the issue has become a global one:

"But the problem of a persistent gap between a central bank's target price index and a separate measure used by the public has recently become more acute in the UK and the US. The Bank of England targets the so-called consumer price index, while most people in the UK sensibly rely on the old retail price index, which gives a far truer picture of the cost of living including housing. Both indices have registered increases recently. But whereas the CPI has most recently grown at an annual rate of 3.1 per cent, the RPI has gone up by close to 5 per cent. The gap between the two is large and persistent. When that happens, a central bank has a problem. On a recent visit to South Korea, I was told that the same was happening there: prices were rising everywhere, yet the price index gives the illusion of price stability."

It's time to admit that "the notion of price stability requires a broader definition. Various indices, house price inflation and the cost of rents and mortgages should all form part of a judgment about price stability." Failing to do that risks the ire of the public. They increasingly lack belief in the government  statistics in general, and there may develop a decreasing faith in Central Bank's credibility in particular.

To paraphrase Munchau, if we are to judge inflation on a broader scale, we would undoubtedly come to the conclusion that like the rest of the world, the US has an inflation problem.


How We Learned to Stop Worrying (so much) and Love “Da Bomb”
Bill Gross
Investment Outlook
PIMCO ¦ May/June 2007

The problem with inflation indices
Wolfgang Munchau
Financial Times, May 14 2007 03:00